What is the Economics of Ratings Agencies?

The Who have that song “Won’t be fooled again”  .  Are the folks at the rating agencies whistling that song?   In a repeated game, reputation matters. If ratings agencies want to continue to attract business, they have incentives to build a reputation as a “trusted straight shooter”.   In my preferred world,  rating agencies would be randomly assigned to the party that they will rate.  This would negate conflict of interest issues that clearly arose and helped to cause “junk” to receive a AAA rating.

A silver lining of the 2008 Crisis is that there is more doubt in investors’ minds about the increased chance of “fat tail” risk.   Don’t believe me?  Well, listen to these fat cats.

These guys are looking for the “straight talk express” and the Ratings Agencies know this.  A big question in modern game theory is how do you build up a credible reputation?  So, if you want to be perceived as tough — do you punch a bully or invade a nation?   The Ratings Agencies are now trying to signal that they are a credible source of information.  I think they have the right incentives now to do the basic research to provide an accurate forecast (given all available information) about future default risk.   Do the agencies have the “human capital” to do the research right?  Well, I would need more information to answer this.

Author: Matthew E. Kahn

Professor of Economics at UCLA.

11 thoughts on “What is the Economics of Ratings Agencies?”

  1. I don’t think fixing the rating agencies’ problems is that simple. It does eliminate the bias to rate high, but what would the incentive be for a ratings agency to have any quality control at all if its customers (the issuers) were all going to be randomly assigned? Why do you need a reputation in this scenario? Avoid malfeasance and you should be golden.

    I would suggest that ratings agencies should get a large part of their compensation in structured notes whose payout is based (in some way about which I am going to wave my hands) upon the average default rate of each of their ratings classes over time. It shouldn’t be too hard to get an i-bank to create these, especially as their returns should be negatively correlated with bonds.

  2. To know whether this model is right, it would be helpful to know whether S&P’s claim that the U.S. government, which prints dollar bills, is at risk of defaulting on its dollar-denominated debt. If someone can explain to me how this isn’t complete nonsense, then I’m prepared to entertain the suggestion that the S&P downgrade threat contains information – as the high ratings S&P accorded to obvious junk clearly did not. Otherwise, the simplest model is that most of S&P’s customers benefit from lower taxes on the wealthy, and that this is a pure play to appeal to their interests at the expense of a borrower that doesn’t pay S&P fees: you and me.

  3. I’m with NYShooter over in the other thread. It’s not humanly possible to be sufficiently cynical about these guys, especially when you think about the real immediate incentives they and everyone else have been operating with. The amounts of money involved, and the hot-house atmosphere they operate in, are profound enough that we really need to throw almost all normal good-faith assumptions totally out the window.

    My own initial reaction on hearing about this “warning” of a “possibly, maybe, down-the-road need to think about downgrading” that isn’t really a downgrading was a combination of two things. First, what’s pending that they want to flex a little muscle about? and second, isn’t this meant as a shot across the bows to show the political world who really runs the country?

    On the first point, we learn the expiry of a two-year hold on a Franken rule is pending (rim shot). It apparently means potentially hundreds of millions or billions in ratings fees.

    On the second, I don’t entirely agree that Obama’s the sole target. Tea-party zealots might also need a little leash-pulling: yes, they’re fine with letting looters run the shop, but if anyone’s going to muck up the debt-ceiling vote it’ll be them; they’ve got to stop screwing around with the potential value of Uncle’s debt. Could cost somebody real money if they’re not careful. Intransigence, more than a couple of percent hike in their own marginal taxes, is what most deeply threatens their livelihoods. Unlike the Kochs and other natural-resource and ag guys, these people make their money passing risk like a hot potato. They’re more afraid of the music slowing down than they are of taxes. The reverse tends to be the case for the ones who deal in tangibles, I think.

    As a matter of intellectual honesty, I really do think that when we try to understand people who show themselves to be utterly cynical in their actions, the prudent approach is to be cynical about them. Personally I’m okay if that sounds cynical.

  4. I couldn’t read past the subscription wall, but I’m wondering, do hedge fund people even use ratings agencies? wouldn’t they just have their own people do it, or have some fancy-pants way of discounting the ratings, since they seem unreliable? They are supposed to be so much smarter and more sophisticated than the rest of us, right?

  5. Anomalous is right. And the most relevant line from the song may be the one at the end: “Meet the new boss / Same as the old boss.”

  6. Matthew: ” In a repeated game, reputation matters. If ratings agencies want to continue to attract business, they have incentives to build a reputation as a “trusted straight shooter”. In my preferred world, rating agencies would be randomly assigned to the party that they will rate. This would negate conflict of interest issues that clearly arose and helped to cause “junk” to receive a AAA rating.”

    Let’s see now – they collected a lot of money to fradulently rate junk bonds as triple-A, did not get prosecuted, and (last I heard) have not been successfully sued. And are still in business, big-time.

    So what are their incentives, again?

    Matthew, do you believe in incentives?

  7. In a repeated game, reputation matters.

    True that. But why is it a repeated game? Matthew Kahn is personifying corporations, and assuming that their indefinite lifespan implies that they will act as indefinite repeat players. Not so. Corporations are run by human beings, who don’t live forever, and aren’t responsible for losses accrued after their term expires. The incentives of the control parties tip strongly toward looting of reputation built up by the previous team. This, too, is a bit too simple. There is such a thing as pride of craft, and boards of directors and shareholders mean something, even though not much. But it does mean that “reputation” doesn’t have much predictive power.

    If you think about it for a moment, an organization built to maximize reputation is likely to be a not-for-profit: ideologically-driven, low-power incentives for executives, active board of directors, mission defined independently of revenue. Or perhaps a coop, which is like a not-for-profit except for the ideology.

    Let’s put it this way, would you rather get your health care from a not-for-profit or a business corporation?

  8. Mark: “… it would be helpful to know whether S&P’s claim that the U.S. government, which prints dollar bills, is at risk of defaulting on its dollar-denominated debt. If someone can explain to me how this isn’t complete nonsense ..”
    Is default the only risk that goes into a sovereign debt rating? The government of Zimbabwe hasn’t SFIK defaulted on its national-currency debt (it did on its hard-currency), but nobody sensible would ever buy the stuff because of inflation.

    I think I’m on the side of S&P on this one, in spite of their massive failures over structured securities and Eurozone peripheral countries, political anti-government bias, and herd behaviour. The move they are making is the absolute minimum – signalling a possible downgrade from AAA (“absolutely sure thing”) to AA+ (“very sure thing”) sometime in the future. They are saying in effect that there is now a teeny risk that the US government, thanks to the incompatibility of its antique constitution with the configuration of its modern party politics, including one party with a large crazy wing, will have real problems paying its debts in future and will have to resort to financial tricks and politically vulnerable devices such as printing money. This looks fair enough to me.

    If the GOP does provoke a debt ceiling crisis – clearly a nonzero risk – , payments on the debt will be a choice for the executive, against say not paying the military or suspending Medicare. They would probably sacrifice Medicare first – but that can’t be guaranteed.

    Banana republic? No, but a normal one, not an Olympian superstate.

  9. One item that seems often left out of discussions about the rating agencies is how a rating such as AAA can apply to such disparate entities as basic bonds and exotic structured finance vehicles. These agencies lent an imprimatur of high ratings to instruments they neither evaluated nor understood. The buying public wasn’t “in” on the secret understandings, and now the ratings agencies cannot expect business as usual to resume.

    First of all, any rating should clearly identify the class of instrument. (Stock, bond Hybrid etc). Secondly, the agency should be required to disclose whether traditional independent evaluation methodologies were performed, and clearly any rating derived from an exotic financial model should be marked as an “at risk” type investment. Third, it seems that the rating agencies should be obligated to carry a surety bond related to rating activities.

    Very clearly one of the most vital elements in the corruption of our financial system is the absolute absence of liability and responsibility of all parties in the chain from end to end. 30 years of Reagan inspired jihad against regulation and the staffing of the judiciary with right wing zealots has gutted all notions of responsibility and any fear of retribution.

    It isn’t really clear what if any path would lead us back to a world where our financial exchanges are any but casinos. I don’t buy into the “black swans” or “fat tails”. All of what happened is well within the range of the mean when one goes pedal to the metal, end to end with corruption and fraud. Real estate is the perfect example of a the chain of fraud from the realtors, to appraisers to lenders, to underwriters etc. They ALL had to be in on it!

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