Definition of rating feedback effects

Rating downgrades often severely increase a company's immediate cost of debt. Debt becomes costly due to regulatory restrictions that limit investors' holdings of lower rated debt or because of rating-based pricing in loan or bond contracts. The increase in credit costs, however, reduces the firm’s creditworthiness so that the initial rating change has a feedback effect that further impairs the firm’s credit quality. At the extreme, this may result in a death-spiral in which a rating downgrade triggers a firm’s default.

Example

While Enron experienced major problems throughout 2001, its rating remained “investment grade“ until November 28. Four days later, Enron filed for bankruptcy. This extreme decline in creditworthiness was partly due to rating feedback effects: Since Enron had a vast amount of debt capital related to rating triggers, the downgrade from investment-grade to junk-bond status caused massive liquidity problems that eventually sealed Enron's fate. [1]

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