Cherry-Picking and Asset Complexity: 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 cherry-pick 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 cherry-pick is low. When assets are sufficiently complex, ratings differ enough that an incentive to cherry-pick 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 buyer-initiated ratings system alleviates the bias, but could collapse the market for information. Most market observers attribute the recent credit crunch to a confluence of factors: lax screening by mortgage originators, improperly estimated correlation between bundled assets, marketdistorting regulations, rating agency conflicts of interest, and a rise in the popularity of new asset classes whose risks were difficult to evaluate. 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 ”cherry-picking,” either by the asset issuers who purchase only the highest ratings, or by ratings agencies who pick flattering facts to increase their probability of selling the rating. Former secretary of labor, Robert Reich, explains:1 ”Why Credit-rating Agencies Blew It: Mystery Solved,” available from http://robertreich.blogspot.com/2007/10/they-mystery-of-why-credit-rating.html . Other articles making similar arguments include ”Stopping the Subprime Crisis” New York Times, July 25, 2007, ”When It Goes Wrong” The Economist, September 20, 2007, ”Credit and Blame” The Economist, September 6, 2007.