A primer on rating agencies as monitors: an analysis of the watchlist period

In much of the literature, rating agencies are seen as institutions providing informational services to the market. Our paper contributes to this literature by looking closely at the watchlist period, a particularly well-defined monitoring event. We are interested in the evolution of default risk expectations over the watchlist period. The change in the firm’s distance to default, relative to a benchmark group of firms, serves as our metric of market expectations. Using a complete data set of Moody’s watchlist operations since 1991, we find that sorting of firms by abnormal change in distance to default only partially explains the rating decision. Relying on a clean sample of watchlist initiations with no prior, we find a significant abnormal return which can be explained by proxies for the agency cost of debt. Since market expectations rely on publicly available information, we conclude that private information plays a role in the eventual rating assignment. Our results provide indirect evidence for an active monitoring role of rating agencies, as recently suggested by Boot, Milbourn, and Schmeits (2006).