Ratings Agencies Incentivized By Incentives, Part 2

A thing about credit ratings is that issuers pay for ratings, and the issuers who pay more get better ratings. This is a problem that many people want to solve either by the obvious approach of having someone else pay for ratings or by the fancier approach of having issuers pay for ratings but not letting agencies compete directly for that money.

Today a paper by three accounting professors reminds us that the first approach has been tried, and not just by Egan-Jones. In the early 1970s, while Moody’s was charging issuers for ratings, S&P was still charging investors, so there was a period where you could directly compare the ratings of two big established agencies, one of whom had incentives to give actionable advice to investors, the other of whom had incentives to give good ratings to issuers. You will not be surprised at what happened:

Using a sample of 797 corporate bonds issued between 1971 and 1978 and rated by both S&P and Moody’s, we find that, between 1971 and June 1974, when Moody’s charged issuers for bond ratings and S&P charged investors, Moody’s ratings are on average higher than S&P’s ratings for the same bond. During the period both S&P and Moody’s charge issuers for bond ratings—July 1974 through 1978—we find that Moody’s ratings are no longer higher than those of S&P. Further analyses indicate that this change in the difference between the two agencies’ ratings derives from an increase in S&P’s ratings around 1974, rather than from any change in Moody’s ratings. This finding supports the view that the issuer-pay model leads to higher bond ratings.

That’s not the only lesson from the past that may be relevant to our crazy modern world with its, um, faster-than-light travel. The authors point out that the switch from investor-pays to issuer-pays in the 1970s was largely driven by technology: “At the same time, advances in information sharing technology—namely, the fax and the photocopy machine—exacerbated the free rider problem, which, in turn, prevented rating agencies from raising their subscription prices or increasing their circulation.” If your paywall is porous, it is hard to charge investors for ratings.

That is more, not less, of a problem today, since we’ve made good use of our ever-faster neutrinos to improve on the fax machine. And in a world with CNBC, ratings without free or quasi-free dissemination don’t really get much credibility. If you want people to pay for your ratings, they have to care about them, and if you don’t publicize your ratings freely then you won’t ever get enough people to care about them. Remember when Egan-Jones downgraded the U.S. and Congress and the President and the press freaked out? No?

But today the marginal user of ratings is not someone who is looking for a better informed, carefully thought out perspective on credit quality. (Maybe it was before the switch to issuer-pays in the ’70s?) That’s driven in part by the fact that raters don’t seem to be all that much better informed, but the main issue is that ratings are far more valuable for complying with charter and regulatory requirements than they are for investment analysis. Regulators are trying to trim that around the edges, but it is not obvious that they’re having much luck. And even if they do, it’s hard to imagine an “investment grade bond fund” being anything other than a fund that invests in bonds rated IG by one or more well-known agencies.

This got us to noodling on whether there might be a compromise that would allow an investor-pays model without having to worry about free riders. The SEC, Fed, etc. could let banks/brokers/funds rely on third-party ratings as part, maybe the main part, of their credit risk analysis in categorizing securities for money-market fund qualification, broker-dealer capital requirements, bank capital, etc. But they’d have to pay for those ratings, maybe based on the size of the portfolio for which they rely on ratings. Ratings agencies could publish ratings without getting paid by issuers, and make those ratings available free to anyone who wants to read them, but any broker-dealer/money market fund/bond fund that used the agency’s ratings to comply with regulations or its charter would have to pay.

That probably solves the free rider problem, since it’s enforceable, as long as the SEC and Fed cooperate and funds have to disclose to regulators and investors whose ratings they rely on. It doesn’t exactly solve the incentives problem, since most of those who use ratings for regulatory purposes tend to want their stuff rated higher rather than lower. (Though you could imagine some junk bond fund managers being fond of a rater who gives BBB-ish credits BB+ ratings.) But it does make it easier: investors who want really safe investment-grade bond mutual funds, or money market investments, will go to managers who advertise “we only buy bonds rated investment grade by the toughest agencies” – and since ratings would be public, anyone could find out who the toughest agencies are. Similarly, regulators could look more closely at the books of brokers and banks who meet their capital requirements using ratings from generous agencies, while giving a bit more slack to those who use tougher ratings.

Anyway. Just an idea. Thoughts?

Does it Matter Who Pays for Bond Ratings? Historical Evidence [SSRN, via Harvard Law governance blog]
Related: Ratings Agencies Incentivized By Incentives
Also related: What Are You Paying Ratings Agencies Zero Dollars For, Anyway?

70 comments (hidden to protect delicate sensibilities)
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Comments (70)

  1. Posted by I'm a Dude | November 18, 2011 at 12:53 PM

    although i didn't even try to read Matt's post, i'm dying to know why there's a picture of a cow.

  2. Posted by Fred | November 18, 2011 at 12:56 PM

    "We don't have a cow. We have a bull."

  3. Posted by FKApmco | November 18, 2011 at 12:57 PM

    Dude, it's a DB tradition. I believe based on the notion that Moody's is a ratings agency and cows say moo. Some think it udderly ridiculous but I have no beef with it.

  4. Posted by lex luthor | November 18, 2011 at 1:00 PM

    No shit. And big democrat donors get a fat taste of stimulus dollars. You are new to the game, huh?

  5. Posted by Guest | November 18, 2011 at 1:03 PM

    Remember folks this was only Part 2.

  6. Posted by FKApmco | November 18, 2011 at 1:06 PM

    Dear Matt: thoughts on your proposition…it is fatally flawed to believe the SEC and The Fed can cooperate about anything.

    Thoughts on other things:
    1. South Park this week was wicked.
    2. I have had enough of work for this week.
    3. I might have a bubble bath when I get home tonight.
    4. Do you think Jess & Bess will do a live blog when Seinfeld hosts Regis & Kelly next week?

  7. Posted by Guest | November 18, 2011 at 1:11 PM

    Really trying to milk that joke for all its worth huh?

  8. Posted by Moooooo | November 18, 2011 at 1:12 PM

    That cow is Matt. Matt wrote the article. Therefore the article was written by a cow.

  9. Posted by FKApmco | November 18, 2011 at 1:21 PM

    Listen Hoss, I woke up in a good mood this morning and I'm not going to take any bull from you today, okay?

  10. Posted by ih8edjfkjr | November 18, 2011 at 1:24 PM

    I'd read a Matt Levine post even if cows wrote the tags.

  11. Posted by Milkster | November 18, 2011 at 1:26 PM

    Don't you mean a good mooooood?

  12. Posted by Matt Fan | November 18, 2011 at 1:31 PM

    Please see the following chart

    Tag Quality
    | *
    | *
    | *
    # Cows in post

  13. Posted by trojan_ | November 18, 2011 at 1:32 PM
  14. Posted by Guest | November 18, 2011 at 1:34 PM

    Just be grateful we didn't get a graph. Friday's usually graph day.

  15. Posted by guest | November 18, 2011 at 1:35 PM

    Don´t you just wanna kiss that sweaty nose…

  16. Posted by FKApmco | November 18, 2011 at 1:41 PM

    Indeed I did, Milkshake. But sometimes it behooves one to use subtle humor.

  17. Posted by el duderino | November 18, 2011 at 1:43 PM

    you know Matt, that's just like, your opinion man

  18. Posted by Madison Capital LLC | November 18, 2011 at 1:47 PM

    Nudie magazine day > graph day

  19. Posted by I Remember | November 18, 2011 at 1:48 PM

    It references a Moody's chatroom screen shot before the crisis. It basically had one dude saying "I can't believe we just put a AAA rating on that CDO!" and another one saying "I would AAA a cow's utter if they paid me enough".

  20. Posted by TheDetailGuy | November 18, 2011 at 1:49 PM

    stopped reading at "paper by three accounting professors"…

  21. Posted by guest | November 18, 2011 at 1:55 PM

    Bubble bath? Ughhhhhh… using bath gel? Or, oooh, smelling salts?

    – inmate 369
    Vandalia, Ohio

  22. Posted by PermaGuestII | November 18, 2011 at 2:11 PM

    More cowbell.

  23. Posted by Guest | November 18, 2011 at 2:26 PM

    Serious comment (sorry about that), but this would reinstate the government-granted ratings agency monopoly, just as Dodd-Frank attempted to remove it. The magic "NRSRO" rating would be key not just to driving business, but would literally be required for ratings agencies to get any business at all.

    The main risk there is that as the ratings agencies become subject to the government's approval, or not, they become subject to the government's influence on what ratings should be. Enough corporations (or GSEs) don't get their coveted AAA ratings, they call up their members of Congress and complain, Congress leans on the regulators, and the regulators end up telling the NRSROs how to do their ratings. That's moving things in the wrong direction.

  24. Posted by spectre | November 18, 2011 at 2:26 PM

    For some reason, I kind of want to punch it.

  25. Posted by Jimb | November 18, 2011 at 3:02 PM

    It's RATING agency or agencies, not RATINGS agency. You ppl drive me crazy!

  26. Posted by Relaxed Ratings Wasp | November 18, 2011 at 3:17 PM

    "You ppl" what's that supposed to mean? You know it's not nice to prey on people you already know are nervous, not nice at all.

  27. Posted by Guest | November 18, 2011 at 3:26 PM

    Cmon Matt, you could have hyperlinked at least 20 more words

  28. Posted by FKApmco | November 18, 2011 at 3:30 PM

    Sorry Jimbo, my bad. The only reason to be so Shitty & Piggish about it is if you are menopausal…then it's ok to be a Moody bitch.

  29. Posted by whowhawhen | November 18, 2011 at 4:43 PM

    I want to give you a -1 for obviousness, but I feel some here actually needed reminding, so +1?

  30. Posted by Citations Compliance | November 18, 2011 at 4:54 PM

    "That deal could be structured by cows and we'd rate it." http://voices.washingtonpost.com/economy-watch/20

  31. Posted by I Think I Remember | November 18, 2011 at 5:02 PM

    After reading the comments, I think people forgot/are new/did too much blow.

  32. Posted by Guest | November 18, 2011 at 9:17 PM

    I actually like the cows.

  33. Posted by crediteye | November 20, 2011 at 10:31 PM

    Dont rely on rating agencies. See the ratings methodologies described in the book "Stories In Credit Analysis : How to protect your investment portfolio from rating agencies, Quants and other Quacks"

  34. Posted by Xzibit | November 21, 2011 at 4:23 PM

    Yo dawg, I herd you like incentives so I put some incentives in ur wallet so we can create an issue while you rate my issue!

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