18 November 2008

Fixing Credit Rating Agencies

And now for something completely different...

I read yet another story on how the credit rating agencies (Standard and Poors, Moodys, Fitch, et al.) failed at their task of rating credit instruments (bonds, derivatives, etc.) to reflect the risk of those instruments.

The credit rating business works like this: Companies that want to issue instruments pay the agencies to rate them (AAA, BBb, etc.) for risk. The companies then sell instruments on the market to buyers who look at the rating when deciding how much to pay. The higher the rating, the higher the price that the companies will get, and the less risk the buyers think they are taking on.

Now there's a clear conflict of interest: Companies paying agencies want a high rating, agencies have an incentive to give high ratings (in exchange for bigger fees, more future business, etc.), but buyers depend on agency ratings.

Unfortunately, buyers cannot pay the agencies. They cannot pay in advance (they are not sure they will buy until AFTER ratings are done), and -- even if they did -- they would suffer from free-riding (if some buyers pay for the rating, other buyers can use that information without paying).

So, how do we fix the system (improving accuracy) while maintaining the current payment relationships? Change incentives in this way:
  1. Set a standard fee for rating that depends on the type of instrument, the size of the issue, etc. Such standardization would remove one obvious problem (negotiated fees) while giving agencies an incentive to turn down business that's too complicated to understand.
  2. Track the performance of all instruments rated by an agency in a given credit category (e.g., AA-) against all others in that category. Those that underperformed (price fell below the average) are probably riskier than the initial rating indicated, i.e., the agency was overoptimistic. Performance ratings should be weighted by the age of the instrument/rating, the size of the issue, etc.
  3. Adjust each agency's fees to equal some fraction of the standard fee based on that agency's performance relative to other agencies, e.g., 80% if ratings are too high (missing hidden risk) or 110% if the ratings are too low (seeing non-existing risk).
Under this system, buyers could observe how accurate agencies are, and companies would have an explicit notion that they are paying for a rating of an agency that's often too optimistic/pessimistic, etc.

Note that this system depends on competition, so it's important to avoid cartels, oligopoly, etc. Even if standard prices are "set" (good place for a regulator), the competition will take place ex-post, when markets "reveal" the quality of the agencies' work.

Also note that #2 alone could do quite a lot to improve matters, but it's nice to link income to performance (#1 and #3).

Bottom Line: We need credit ratings, but we need to punish rating agencies that do a bad job, and the market is the best place for punishment.

Addendum: Cross-posted at AngryBear

4 comments:

Emmanuel said...

I think delinking direct relationships between firms and NRSROs makes sense in avoiding conflicts of interest. This can perhaps be accomplished by collection of rating agency fees at the industry level or at another level of aggregation where the acts of fee collection AND rating are (nearly) "double-blind": firms are unaware of which agency or agencies will rate them and agencies don't know which firms paid the fees.

Better yet, make users of rating information shoulder a larger part of paying for these ratings. It creates more of an incentive on the agencies' part to be accurate to begin with.

David Zetland said...

@emmanuel: Nice idea, but it's almost impossible for companies to NOT know who's rating them. They have to meet, discuss, etc.

Sharing fees out of proportion to work done or quality is also asking for trouble (free riding, etc.)

TokyoTom said...

David, the rating system is fundamentally flawed because of regulation that restricts assets that regulated entities may purchase and mandates capital based on ratings.

As a result, there really isn't a free market for ratings, driven by investor desires to control risk. If the market were driven from the investor side, mechanisms would develop to deal with the issues you point to.

David Zetland said...

@TT -- I agree about the regulatory problem, but proper markets are hard to establish with the free riding problem. All I do (in terms of intervention) is set the fee, restricting the bidding for work option. Theoretically, this restriction is not required (investors would detect flaws in Bribe-high fees), but reality tends to have more ignorance.