The Credit Ratings Game

Abstract

The collapse of AAA-rated structured finance products in 2007 to 2008 has brought renewed attention to conflicts of interest in credit rating agencies (CRAs). We model competition among CRAs with three sources of conflicts: (1) CRAs conflict of understating risk to attract business, (2) issuers' ability to purchase only the most favorable ratings, and (3) the trusting nature of some investor clienteles. These conflicts create two distortions. First, competition can reduce efficiency, as it facilitates ratings shopping. Second, ratings are more likely to be inflated during booms and when investors are more trusting. We also discuss efficiency-enhancing regulatory interventions.

Ratings Hardwiring and Asset Prices

“…6 However, asset pricing implications that arise from ratings hardwiring have received scant attention in the theoretical literature, which focuses primarily on equilibrium bias in produced and in reported ratings. Bolton et al (2012) show that, in the presence of ratings shopping by issuers, competition among rating agencies can reduce efficiency and inflate reported ratings in equilibrium, especially in boom periods when there are more trusting investors. That is consistent with Becker and Milbourn (2011), who provide evidence of less informative ratings when competition in the ratings market increases.…”

“…In addition to ratings hardwiring, we assume that noise traders also trade for non-fundamental (liquidity) purposes a la Grossman and Stiglitz (1980). 3 The distinction between informed traders and uninformed investors who hardwire their investments to ratings shares some parallels with the distinction between sophisticated and trusting investor clienteles in Bolton et al (2012). They argue that the coexistence of the two types of agents may be due to different compensation schemes that lead to different incentives to carry out due diligence, or regulatory and internal charter restrictions that force certain types of investors to hold assets with ratings only above a certain threshold.…”

What is Subordination About? Credit Risk and Subordination Levels in Commercial Mortgage-backed Securities (CMBS)

“…Riddiough and Zhu 2009;Sangiorgi and Spatt 2011;Bolton et al 2012;Bongaerts et al 2012;Stanton and Wallace 2012). It also contributes to our understanding of how the structured finance products are designed (see, e.g., He et al 2012;Furfine 2012;Ghent et al 2013).…”

“…Subsequently, there have been heated debates on whether the CRAs had inappropriate credit ratings and subordination design (see, e.g., Griffin and Tang 2012;Bolton et al 2012;Cohen and Manuszak 2013). The issuer of a CMBS deal has the incentive to increase their returns by maximizing the number of senior bonds produced by the deal by providing the minimum level of subordination required to receive a AAA rating.…”

Fear of rejection? Tiered certification and transparency

“…Like these papers, we assume that certifiers have sufficient governance or reputation to abide by the reporting rule that they announce . Certifiers' reputation building is analyzed in Biglaiser (), Bolton, Freixas, and Shapiro (), Bouvard and Levy (), and Mathis, McAndrews, and Rochet (). Relatedly, our focus on coarseness relates to the very extensive literature on cheap talk.…”