Estimating Unobserved Soft Adjustment in Credit Rating Models: Before and after the Dodd–Frank Act.

The article focuses on modeling and empirically estimating the "soft adjustment" in corporate bond ratings by Credit Rating Agencies (CRAs), specifically Moody's, and assessing changes following the Dodd–Frank Wall Street Reform and Consumer Protection Act. Soft adjustment refers to bond-specific, qualitative rating modifications based on nonpublic information or potential rating biases due to conflicts of interest, which cause endogeneity in bond characteristics. The authors develop a semiparametric ordered-response model that treats soft adjustments as firm-specific thresholds and use the ownership structures linking bond issuers and Moody's shareholders to control for endogeneity. Empirical analysis of Moody's initial bond ratings from 2000 to 2016 reveals a significant reduction in the dispersion of soft adjustments after Dodd–Frank, indicating increased rating transparency and stricter criteria, especially for bonds connected to Moody's large shareholders. The study highlights the evolving role of soft information in credit ratings and the regulatory impact on mitigating conflicts of interest within the credit rating industry.