Ratings Agencies Incentivized By Incentives, Part 2

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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?

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