Why Do CDO Downgrade Announcements Impact the Bank’s Share Price?

Abstract

The collapse of the collateralized debt obligation (CDO) market brought attention to the soundness of the involved banks. We infer equity price reaction from rating announcements that are either negative rating outlooks or rating downgrades of CDO. To explain the market reactions, we consider rating shopping and rating grade inflation, reputation of rating agencies, sophisticated or trusting investor behavior and informational asymmetry. While these approaches are not mutually exclusive, our results indicate strong support for regime and time dependency of the sophisticated or trusting investor behavior and informational asymmetry. The trusting investor was dominant in times of market growth right before the outbreak of the financial crisis. This perception has changed so that the sophisticated investor is dominant. Even though rating announcements were expected, feedback channels exist that result in losses. When comparing the stock price reaction of bank related rating announcements, we find that the long term financial outlook is a decisive factor for the investor. As such, we take the bank’s issuer rating and perceive that price effects are well anticipated before the actual announcement day. We interpret the differing market reactions with the availability of information and refer this to an informational asymmetry issue.