Rating the Agencies

It's being argued that yesterday's downgrade of the credit rating of the United States government by Standard and Poor's could increase borrowing costs throughout the economy, worsen the burden of debt, retard a recovery that already appears to be faltering, affect political brinkmanship in future negotiations, and further tarnish our national reputation.

Unless, of course, we chose to collectively ignore it, as Dan Alpert recommends:

Effectively – the S&P pronouncement last evening amounted to not much more than a guest in your house telling your children to clean up their rooms “or else.” I don’t know about you, but in my case, at least, I would ask such a guest to apologize or leave.

But it's difficult to ignore events on which everyone else is lavishing such great attention, and this seems like an appropriate time to examine how these agencies managed to gain such visibility and influence. As Ross Levine notes in his recent autopsy of the financial crisis, this is where we stood forty years ago:

Until the 1970s, credit rating agencies were comparatively insignificant, moribund institutions that sold their assessments of credit risk to subscribers. Given the poor predictive performance of these agencies, the demand for their services was limited for much of the twentieth century (Partnoy, 1999). Indeed, academic researchers found that credit rating agencies produce little additional information about the firms they rate; rather, their ratings lag stock price movements by about 18 months (Pinches and Singleton, 1978).

But then a policy shift occurred that continues to have major ramifications to this day. The SEC provided a special designation to a class of rating agencies and then proceeded to use their opinions as a basis for setting capital requirements. The selected agencies suddenly found themselves endowed with vastly increased market power and a very lucrative business model:

In 1975, the SEC created the Nationally Recognized Statistical Rating Organization (NRSRO) designation, which it granted to the largest credit rating agencies. The SEC then relied on the NRSRO's credit risk assessment in establishing capital requirements on SEC-regulated financial institutions.

The creation of – and reliance on – NRSROs by the SEC triggered a cascade of regulatory decisions that increased the demand for their credit ratings. Bank regulators, insurance regulators, federal, state, and local agencies, foundations, endowments, and numerous entities around the world all started using NRSRO ratings to establish capital adequacy and portfolio guidelines. Furthermore, given the reliance by prominent regulatory agencies on NRSRO ratings, private endowments, foundations, and mutual funds also used their ratings in setting asset allocation guidelines for their investment managers. NRSRO ratings shaped the investment opportunities, capital requirements, and hence the profits of insurance companies, mutual funds, pension funds, and a dizzying array of other financial institutions.

Unsurprisingly, NRSROs shifted from selling their credit ratings to subscribers to selling their ratings to the issuers of securities. Since regulators, official agencies, and private institutions around the world relied on NRSRO ratings, virtually every issuer of securities was compelled to purchase an NRSRO rating if it wanted a large market for its securities. Indeed, Partnoy (1999) argues that NRSROs essentially sell licenses to issue securities; they do not primarily provide assessments of credit risk.

This shift in business model by the selected agencies raised some rather obvious conflicts of interest, since their customers were now issuers of debt who stood to gain from overly optimistic assessments of their credit risk. As is common in such cases, the counterargument was made that the need to preserve one's reputation for accuracy would provide adequate incentives for objective ratings:

There are clear conflicts of interest associated with credit rating agencies selling their ratings to the issuers of securities. Issuers have an interest in paying rating agencies more for higher ratings since those ratings influence the demand for and hence the pricing of securities. And, rating agencies can promote repeat business by providing high ratings...

Nevertheless, credit rating agencies convinced regulators that reputational capital reduces the pernicious incentive to sell better ratings. If a rating agency does not provide sound, objective assessments of a security, the agency will experience damage to its reputation with consequential ramifications on its long-run profits. Purchasers of securities will reduce their reliance on this agency, which will reduce demand for all securities rated by the agency. As a result, issuers will reduce their demand for the services provide by that agency, reducing the agency's future profits. From this perspective, reputational capital is vital for the long-run profitability of credit rating agencies and will therefore contain any short-run conflicts of interest associated with “selling” a superior rating on any particular security.

I have previously discussed some of the limitations of this argument in a different context, and such limitations were clearly evident in the case of the agencies:

Reputational capital will reduce conflicts of interest, however, only under particular conditions. First, the demand for securities must respond to poor rating agency performance, so that decision makers at rating agencies are punished for issuing bloated ratings on even a few securities. Second, decision makers at rating agencies must have a sufficiently long-run profit horizon, so that the long-run costs to the decision maker from harming the agencies reputation outweigh the short-run benefits from selling a bloated rating.

These conditions do not hold, however... regulations weaken the degree to which a decline in the reputation of a credit rating agency reduces demand for its services. Specifically, regulations induce the vast majority of the buyers of securities to use NRSRO rating in selecting assets. These regulations hold regardless of NRSRO performance, which moderates the degree to which poor ratings performance reduces the demand for NRSRO services. Such regulations mitigate the positive relation between rating agency performance and profitability.

This brings us to the role of the agencies in the financial crisis. The rapid growth of structured products provided the agencies with a substantial new source of demand, as well as the problem of assessing credit risk for securities of much greater complexity. Minor changes in modeling assumptions could lead to significantly different ratings for such assets. Nevertheless, there were strong incentives in place for the agencies to act as if they could make competent assessments of credit risk:

The explosive growth of securitized and structured financial products from the late 1990s onward materially intensified the conflicts of interest problem. Securitization and structuring involved the packaging and rating of trillions of dollars worth of new financial instruments. Huge fees associated with processing these securities flowed to banks and NRSROs. Impediments to this securitization and structuring process, such as the issuance of low credit rating on the securities, would gum-up the system, reducing rating agency profits.

In fact, the NRSROs started selling ancillary consulting services to facilitate the processing of securitized instruments, increasing NRSRO incentives to exaggerate ratings on structured products. Besides purchasing ratings from the NRSROs, the banks associated with creating structured financial products would first pay the rating agencies for guidance on how to package the securities to get high ratings and then pay the rating agencies to rate the resultant products.

Other evidence also indicates that rating agencies adjusted their behavior to capture the profits made available by securitization and the design of new structured financial products. Lowenstein's (2008) excellent description of the rating of a MBS by Moody's demonstrates the speed with which complex products had to be rated, the poor assumptions on which these ratings were based, and the profits generated by rating structured products... Indeed, internal e-mails indicate that the rating agencies lowered their rating standards to expand the business and boost revenues... A collection of documents released by the US Senate suggests that NRSROs consciously adjusted their ratings to maintain clients and attract new ones.

The short-run profits from these activities were mind bogglingly large and made the future losses from the inevitable loss of reputational capital irrelevant. For example, the operating margin at Moody's between 2000 and 2007 averaged 53 percent. This compares to operating margins of 36 and 30 percent at Microsoft and Google, or 17 percent at Exxon... Thus, rating agencies faced little market discipline, had no significant regulatory oversight, were protected from competition by regulators and legislators, and enjoyed a burgeoning market for their services... It was good to be an NRSRO.

Levine's bottom line is this:

While the crisis does not have a single cause, the behavior of the credit rating agencies is a defining characteristic. It is impossible to imagine the current crisis without the activities of the NRSROs. And, it is difficult to imagine the behavior of the NRSROs without the regulations that permitted, protected, and encouraged their activities.

Perhaps the time has come to consider a complete overhaul of this dysfunctional system. Withdraw the special designation accorded to the major agencies, so that they compete on a level playing field with new entrants. If they really do have the expertise to make assessments of credit risk that are more accurate than the market, let them build reputation and find clients willing to pay for their pronouncements. Make capital requirements for financial institutions independent of ratings, thus stripping the agencies of their monopoly power and guaranteed sources of income. And in the meantime, greet their pronouncements on sovereign debt not with an anxious wringing of hands, but with a collective yawn.

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Update (8/10). Andrew Gelman follows up:

Another way to look at this is: Given all the above, those S&P dudes must really really think the U.S. is at risk of defaulting. Keeping the AAA rating would’ve been the safe default choice. Deciding to downgrade—that’s political dynamite, with a risk of losing their lucrative quasimonopoly. That’s a decision you’d only make for a really good reason. Or maybe they’re just overcompensating for all those bad AAA ratings they gave out a few years ago?

I certainly see his point. But I don't think that the agencies are in much danger of losing their quasimonopoly, which makes the decision a bit harder to interpret as a bold act driven by conviction.