Ratings Shopping and Asset Complexity: A Theory of Ratings Inflation

Many blame the recent financial market turmoil on ratings agencies. We develop an equilibrium model of the market for ratings and use it to examine popular arguments about the origins of and cures for ratings inflation. In the model, asset issuers can shop for ratings – observe multiple ratings and disclose only the most favorable – before auctioning their assets. When assets are simple, agencies’ ratings are similar and the incentive to ratings shop is low. When assets are sufficiently complex, ratings differ enough that an incentive to shop emerges. Thus an increase in the complexity of recently-issued securities could create a systematic bias in disclosed ratings despite the fact that each ratings agency discloses an unbiased estimate of the asset’s true quality. Increasing competition among agencies would only worsen this problem. Switching to a investor-initiated ratings system alleviates the bias, but could collapse the market for information. Life can only be understood backwards; but it must be lived forwards. Soren Kierkegaard (1813 1855) ∗[email protected] and [email protected], 44 West Fourth st., suite 7-180, New York, NY 10012. This paper is being prepared for the Carnegie-Rochester conference series. Many thanks to David Backus, Ignacio Esponda, Valerie Roberta Bencivenga, Dimitri Vayanos and Lawrence White for useful discussions. We also thank participants in the Stern micro lunch for their helpful suggestions. Most market observers attribute the recent credit crunch to a confluence of factors: lax screening by mortgage originators, improperly estimated correlation between bundled assets, market-distorting regulations, rating agency conflicts of interest, and a rise in the popularity of new asset classes whose risks were difficult to evaluate.1 This paper investigates the mis-rating of structured credit products, widely cited as one contributor to the crisis. Our main objective is to critically examine two arguments about why ratings problems arose and show how combining the two could produce ratings bias that would be unanticipated by rational, but imperfectly informed, investors. One argument focuses on asset issuers who shop around for the highest ratings. Former chief of Moody’s, Tom McGuire, explains:2 The banks pay only if [the ratings agency] delivers the desired rating. . . . If Moody’s and a client bank don’t see eye-to-eye, the bank can either tweak the numbers or try its luck with a competitor like S&P, a process known as ratings shopping. While the issuer-initiated ratings system has been around since the 1970’s, ratings bias only recently emerged as a concern. To argue that it took 30 years to detect the bias is to suggest that learning by financial market participants is unrealistically slow. This raises the question: Is it possible that ratings shopping previously had no or a small effect and that something about the credit market changed to amplify its effect? A second argument about why credit derivatives were mis-rated attributes the problem to the increasing complexity of assets. As Mark Adelson testified to congress,3 The complexity of a typical securitization is far above that of traditional bonds. It is above the level at which the creation of the methodology can rely solely on mathematical manipulations. Despite the outward simplicity of credit ratings, the See, for instance, page 1 of the Memorandum for the President from the President’s Working Group on financial markets dated March 13, 2008. Quote from New York Times Magazine, “Triple-A-Failure,” April 27, 2008. Other articles making similar arguments include “Why Credit-rating Agencies Blew It: Mystery Solved,” available from http://robertreich.blogspot.com/2007/10/they-mystery-of-why-credit-rating.html, “Stopping the Subprime Crisis” New York Times, July 25, 2007, “When It Goes Wrong” The Economist, September 20, 2007, and “Credit and Blame” The Economist, September 6, 2007. Adelson: Director of structured finance research at Nomura Securities. Testimony before the Committee on Financial Services, U.S. House of Representatives, September 27, 2007. On January 26, 2008, The New York Times quoted the CEO of Moody’s, saying “ In hindsight, it is pretty clear that there was a failure in some key assumptions that were supporting our analytics and our models.” He said that one reason for the failure was that the “information quality” given to Moody’s, “both the completeness and veracity, was deteriorating.” See also page 10 of the Summary Report of Issues Identified in the Commission Staff’s Examinations of Select Credit Rating Agencies, United States Securities and Exchange Commission, July 8, 2008.