The Credit Ratings Game

The collapse of so many AAA-rated structured ...nance products in 2007-2008 has brought renewed attention to the causes of ratings failures and the con‡icts of interest in the Credit Ratings Industry. We provide a model of competition among Credit Ratings Agencies (CRAs) in which there are three possible sources of con‡icts: 1) the CRA con‡ict of interest of understating credit risk to attract more business; 2) the ability of issuers to purchase only the most favorable ratings; and 3) the trusting nature of some investor clienteles who may take ratings at face value. We show that when combined, these give rise to three fundamental equilibrium distortions. First, competition among CRAs can reduce market e¢ciency, as competition facilitates ratings shopping by issuers. Second, CRAs are more prone to in‡ate ratings in boom times, when there are more trusting investors, and when the risks of failure which could damage CRA reputation are lower. Third, the industry practice of tranching of structured products distorts market e¢ciency as its role is to deceive trusting investors. We argue that regulatory intervention requiring: i) upfront payments for rating services (before CRAs propose a rating to the issuer), ii) mandatory disclosure of any rating produced by CRAs, and iii) oversight of ratings methodology can substantially mitigate ratings in‡ation and promote e¢ciency. JEL Classi...cations: D43; D82; G24; L15