Estimating Unobserved Soft Adjustment in Bond Rating Models : Before and After the Dodd-Frank Act

Credit Rating Agencies (CRAs) adjust preliminary bond ratings with knowledge beyond publicly available information. These unobserved "soft adjustments" may reflect material non-public information and rating biases due to conflicts of interest, making certain bond characteristics endogenous. We model and quantify soft adjustments as bond-specific thresholds in a semiparametric ordered-response model and exploit ownership structures of bond-issuers to control for endogeneity. Relying on a shift restriction between conditional choice probabilities, we develop a location estimator for models of ordered choices with correlated heterogenous thresholds. Using Moody's initial ratings from 2000 to 2016, we find a significant reduction of soft adjustment after the Dodd-Frank reform