The Credit Rating Game

by Robert Waldmann

In my teens when I learned of the existence of credit rating agencies I wondered why private firms with such power weren’t corrupt. Why don’t firms pay bribes to obtain high credit ratings ? I still don’t know the answer but I think that the key is that the ratings are determined according to rules and those responsible for a particular rating have limited discretion. Clearly top management is not easily corrupted — the value of the reputation of the credit rating agency is so huge that no client can afford a large enough bribe.

However, while a single firm can’t compete with the value of the reputation of a credit rating industry a whole set of new financial instruments — say CDO’s can. Financial innovation is good for the credit rating agencies as they have more things to rate for a fee. Generous credit ratings for new instruments encourage financial innovation. This creates a conflict of interest between the credit rating agencies and investors who use the ratings to decide how to invest.

A sort of model with no equations after the jump.

If there were only one credit rating agency (call it Serene’s) that agency might just decide that the knew business was worth the possible damage to reputation if it turned out that the new assets became toxic sludge with significant probability. However, I would imagine that competition might keep credit rating agencies honest. That is I would if I didn’t think about it much. So consider another agency (call it Unusual and Rich). If Unusual and Rich is being generous with credit ratings in order to encourage financial innovation, can Serene’s profit by being tough ?

Let me define tough. One of the traditional requirements for a AAA rating is a long history of promptly meeting scheduled payments. for example definitely making payments on time through the most recent recession and for another making them on time on assets identical to the newly issued one for decades. Clearly innovative instruments can’t possible pass this test — the test of time — for decades. Clearly credit rating agencies decided not to consider a decades long clear credit record necessary for an AAA rating.

Economists said this was crazy. Ratings based on means, variance and covariances over a few years will be vulnerable to a peso problem — that is given the data there is no way of knowing that sample means are terrible estimates of population means which are dominated by a huge possible event which hasn’t happened yet (the classic example is devaluation of the Mexican Peso). That’s what just happened.

Clearly a credit rating agency could have said “We won’t rate anything related to housing AAA, because some experts say we are in a housing bubble which will burst. There is no way to know how these assets will perform if indeed a housing bubble bursts. We will consider the possibility of a housing bubble bursting ruled out if no such even occurs in the next 10 years. Maybe you will get AAA in ten years but, for now, the most you can get is A.” Would said agency have profited by saying that ?

First assume that the market for the services of credit ratings agencies is very odd as there are a few players each of which has a market share of 100% (I think this is realistic but I don’t know). That is issuers of credit pay for ratings from all the major agencies — the fees being tiny compared to the added reputational value of a second opinion. This would tend to reduce the ruthlessness of competition.

Now I wonder why, given the value of a credit rating, the agencies don’t charge huge fees. I think the explanation is simple — credit issuers can’t afford to refrain from seeking a rating from an agency when the only explanation of their choice is that the rating would be low. However, if an agency charges fees totally out of proportion with its costs, it gives credit issuers an excuse to not obtain a rating from it. The key is not that the cost of the rating has increased but that the reputational cost of not getting the rating is much smaller when one can claim that the fee is outrageous and one isn’t paying it as a matter of principle.

This limit on fees makes it possible for fees to be so low that credit issuers obtain ratings from all reputable agencies. It can also mean that an excellent reputation is not worth more than an average reputation. This is certainly possible in a repeated game between agencies, credit issuers and investors (pretty much anything is). In common sense terms it depends on what sort of fees seem unreasonable. I’d say people look at profit margins and for some level decide that they are excessive. A credit rating agency profit margin which seems excessive to investors’ profit margin seems unreasonable to investors makes it unnecessary for credit issuers to obtain ratings from the agency to show that they aren’t afraid of the rating they would get.

Assume profit margins are limited by this mechanism to a level which credit ratings agencies can easily obtain if they are equally reputable. Being better than the other agency may be worth roughly zero. This limits Serene’s’ possible gains from being tough.

The first effect of toughness is a cost, credit issuers won’t ask for ratings (it is better to remain silent and be thought a fool than to open one’s mouth and remove all doubt). In the long run, if there is a bubble and it bursts, Serene’s can gain in reputation compared to Unusual and Rich *if* Unusual and Rich just sits there giving AAA ratings to junk. However, Unusual and Rich won’t do that. They will get tough too, because while it is no problem for both firms to damage their reputation it is very bad for Unusual and Rich to severely damage its reputation while Serene does not.

This means that implicit collusion can be maintained. That is, there is an equilibrium in which both agencies give generous ratings to new instruments and both damage their reputations when the crash comes. This is an unusual result. For a plain old cartel it is more difficult to maintain a collusive equilibrium — a firm can profit in the short run by deviating. In this case, deviating to toughness is costly in the short run and well deviating is always costly in the long run because of the other agencies response.

So in this equilibrium, they rate sludge AAA. Then the crash comes and — so what. They all have roughly equal amounts of egg on their faces. We can’t do without credit rating agencies. They will still get as much business rating non-innovative assets as they would have if they were both tough. The new class of assets might vanish, but that was inevitable given the fact that the new assets are very risky and offer modest returns. The agencies profit from the period in which the toxic assets were issued and rated. So long as they gave similar ratings, the damage to both of their reputations won’t hurt them at all.

Of course it will hurt investors who will have to do more research on their own, since they can’t trust the credit ratings agencies as much as they would have been able to trust them in the world without financial innovation.

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