Sunday, July 13, 2008

Rating agencies and conflicts of interests

The aftermath of the recent sub-prime mortgage bubble had raised serious questions about the accuracy of ratings given to financial instruments and institutions by reputed creidt rating agencies.

Here is a study that claims that reputational concerns, far from lowering the chances of rating agencies making mistakes, may actually end up incentivizing them to overlook the available private information. It identifies two major reasons why rating agencies cannot be trusted.

1. It is likely that market participants are more likely to find out about a mistake when a rating agency gives a good rating than when it gives a bad one - good ratings entail more investor interest and analyst coverage, and a wider range of investors will end up holding the securities of the rated firm. In a situation in which a rating agency faces no competition, it might want to be conservative, issuing bad ratings too often, ignoring both publicly and privately available information that indicate otherwise, as this behaviour minimises the chances of being identifiably wrong. In a situation in which a rating agency faces tough competition, it might prefer to be bold and issue good ratings too often, ignoring both publicly and privately available information that indicate otherwise, in order to gamble on increasing its reputation relative to its competitors.

2. A rating agency assigns a rating based on information that is publicly available to all market participants and information that is privately assembled by its analysts or provided by the firm. This information goes through the rating agency’s credit model to produce a rating. If privately available information is inaccurate or difficult to interpret, or if the credit model is flawed, this may prompt a rating agency to make mistakes and issue an incorrect rating. When a rating agency that is aware of the imperfections in its ratings process finds itself in a situation in which a strongly held public opinion and its interpretation of its private information diverge, a rating agency might just conform to public opinion, issuing the rating that everyone expects, because of fears of being wrong.

Update 1
NYT article on how the rating agencies failed the markets.

Update 2 (2/5/2010)
The Times reports that from 2004 to 2007, agencies made hundreds of millions of dollars rating thousands of deals in residential mortgage-backed securities and collateralized debt obligations. Their fees could exceed $1 million per transaction, on top of annual 'ratings surveillance' fees of tens of thousands of dollars.

Ninety-one percent of the triple-A securities backed by subprime mortgages issued in 2007 have been downgraded to junk status, along with 93 percent of those issued in 2006 and 53 percent of those issued in 2005. On Jan. 30 of 2008 alone, Standard & Poor’s downgraded over 6,300 subprime residential mortgage-backed securities and 1,900 C.D.O.’s.

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