Extreme Market Value Declines: How Well Do Rating Agency Assumptions Hold?

Abstract

S&P Global Ratings has been rating leveraged closed-end funds regulated in the United States under the Investment Company Act of 1940 for more than 30 years. The principal source of repayment for these market value securities is the proceeds from liquidating the underlying pledged collateral. In its rating process, S&P applies haircuts to the value of the pledged securities, discounting their value to cover the potential market value decline during the liquidation period. But how appropriate are these haircut assumptions? This article studies the extreme price changes in two major US stock indexes, the Dow Jones Industrial Average and the S&P 500 Index, using extreme value methods. The analysis compares extreme market value declines to the assumptions S&P uses in its market value securities ratings criteria. Moreover, the analysis estimates the likelihood of observing declines larger than those in the criteria (exceedance probabilities) and the average waiting time to observation of declines of various extreme magnitudes (return periods). From the analysis, we find that the likelihood of exceeding the assumptions in the rating methodology is generally in line with S&P’s rating definitions.