Sunday, March 1, 2009

Ratings inflation and reforming the credit ratings market

Credit ratings market is ridden with conflicts of interest - the Credit ratings agencies (CRAs) conflict of understating credit risk to attract more business and the issuer conflict of purchasing only the most favorable ratings (issuer shopping). The other problems include - issuer payments influencing ratings, issuers shopping for ratings, CRA models varying in precision, barriers to entry creating market power for CRAs, and reputation considerations affectingt decision making. Two excellent NBER working papers examine the inherent dichotomies and incentive disotrtions in the present credit rating models and suggest alternatives.

Vasiliki Skreta and Laura Veldkamp write that an arrangement where security issuers can shop for ratings, solicit ratings from multiple agencies, and then select the best, distorts incentives for both the issuer and rating agencies. Increased competition, especially in the market for complex securities, will only exacerbate the distortions. They suggest two possible alternatives - investors initiated ratings and single rating agency.

Investor-initiated ratings suffer from information-market externalities - information leakage and market collapse due to demand complementarity. Since information requires a fixed cost to discover and is cheap to replicate, efficiency dictates that a discovered piece of information should be distributed to every asset investor so that all investors benefit from lower asset payoff risk. Yet, when investors have to pay for ratings themselves, either no investors or too few may
end up being informed. This problem can be overcome if the buyers of these assets are large investors (as is most likely the case for complex derivative products), who will find it valuable to purchase information.

The second possible solution would be to have one rating agency, a regulated monopoly, that rates every bond, thereby eliminating the possibility of ratings shopping. This does raise concerns about the qreliability of the informaiton provided, as incentives may not be aligned.

Patrick Bolton, Xavier Freixas, and Joel Shapiro find that CRAs are more prone to inflate ratings when there is a larger fraction of naive investors in the market who take ratings at face value or when the costs of their reputations taking a hit are lower. This makes ratings inflation distinct possibility during boom times when "the fraction of naive investors is higher" and "the reputation risk for CRAs of getting caught understating credit risk is lower".

They too find that due to issuer shopping, competition among CRAs in a duopoly is less efficient than having a monopoly CRA, in terms of both total ex-ante surplus and investor surplus. They propose three regulatory interventions, all of which suffer from some problems - the requirement of upfront payments to CRAs eliminates the conflicts of interest for CRAs but still permits shopping by issuers; the prohibition of shopping by enforcing disclosure of all ratings would benefit naive investors; an investors-pay solution may achieve an equivalent outcome but may be difficult to implement.

They finally argue that a "regulatory intervention requiring upfront payments for rating services (before CRAs propose a rating to the issuer) combined with mandatory disclosure of any rating produced by CRAs can substantially mitigate the conflicts of interest of both CRAs and issuers."

Update 1
Mark Thoma writes that "if the rating fees are sufficiently low, if the assets are sufficiently complex, and if the number of firms is sufficiently small - a case that may describe the recent market fairly well - a corner solution will emerge, i.e. it always pays - in expected terms - to collect all the ratings available and then make only the best rating public".

Update 2
James Surowiecki, in this post and this article, links to numerous articles about the problems inherent in rating agencies and proposals to reform them.

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