Gone Shopping: A Theory of Ratings Inflation

Many blame the recent financial market turmoil on malfeasance of ratings agencies, who had incentives to bias their ratings. But these incentives had existed for decades. Why did the ratings bias issue only recently emerge? We model asset issuers who can shop for ratings – observe multiple ratings and disclose only a subset – before auctioning their assets. When assets are simple, agencies’ ratings are similar and the incentive to 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. This is true even if each ratings agency discloses an unbiased estimate of the asset’s true quality. Increasing competition among agencies would not solve this problem. Switching to a buyerinitiated ratings system alleviates the bias, but could collapse the market for information. The recent surge in defaults on subprime mortgages caught the markets off guard because the ratings on their associated financial securities were high. The disparity between the credit rating agencies’ assessment and the realized risk of mortgage-backed securities caused many to allege that the ratings agencies were issuing biased ratings to attract business from asset issuers. But the same institutional structure and the same incentives has existed for decades and for decades. If ratings had been biased for decades, why were investors surprised to learn this in the summer of 2008? What changed to inflate the bias in asset ratings? We show that even if ratings agencies were each issuing an unbiased rating, the bias in disclosed ratings could have increased. In other words, if asset issuers shop around and choose the highest rating to disclose, then even though each rating was an unbiased draw, the rating that is ultimately announced in the maximum realized rating, which is a biased signal of the asset’s true quality. The incentive to engage in such ratings shopping increases dramatically if new, more complex financial securities are issued, which were harder to rate. Harder to rate securities generate noisier ratings. With more noise, ratings have more dispersion and the difference between the highest and lowest rating grows. If this difference were small, asset issuers would announce all ratings because more information reduces investor uncertainty and increases the price they are willing to pay for the asset. But if the difference between ratings is large, the benefit of reduced uncertainty is outweighed by having investors expect higher returns. With dispersed ratings, shopping results in a higher price