The Credit Ratings Game
Working Paper: The Credit Ratings Game
Author/Editor: Patrick Bolton, Xavier Freixas and Joel Shapiro
Summary: The spectacular failure of top-rated structured finance products based on sub-prime mortgages has brought considerable attention to how Credit Rating Agencies (CRAs) manage their con.icts of interest. In this paper, we construct a simple model of the credit rating industry and examine these con.icts and proposed regulatory solutions. We find that CRAs may overstate the quality of the issuer.s investment when there are more naive investors or when reputation costs are lower. More precise information increases current payoffs to overstating, but also increases the probability of getting caught. Duopoly is less efficient than monopoly in terms of both total ex-ante surplus and investor surplus since a duopoly may provide more information, but it also gives the issuer more opportunities to take advantage of naive investors through shopping. Changing the way CRAs are paid to a system of upfront fees (the Cuomo plan) resolves the CRAs.con.ict of interest, but doesn’t prevent shopping, and therefore has a loss of surplus from the impact on naive customers. Upfront fees with a prohibition on shopping is optimal. Switching to an investors-pay model could be optimal as well, depending on regulatory costs. All three plans, however, suffer from a potentially severe moral hazard problem.
Full Text
Author/Editor: Patrick Bolton, Xavier Freixas and Joel Shapiro
Summary: The spectacular failure of top-rated structured finance products based on sub-prime mortgages has brought considerable attention to how Credit Rating Agencies (CRAs) manage their con.icts of interest. In this paper, we construct a simple model of the credit rating industry and examine these con.icts and proposed regulatory solutions. We find that CRAs may overstate the quality of the issuer.s investment when there are more naive investors or when reputation costs are lower. More precise information increases current payoffs to overstating, but also increases the probability of getting caught. Duopoly is less efficient than monopoly in terms of both total ex-ante surplus and investor surplus since a duopoly may provide more information, but it also gives the issuer more opportunities to take advantage of naive investors through shopping. Changing the way CRAs are paid to a system of upfront fees (the Cuomo plan) resolves the CRAs.con.ict of interest, but doesn’t prevent shopping, and therefore has a loss of surplus from the impact on naive customers. Upfront fees with a prohibition on shopping is optimal. Switching to an investors-pay model could be optimal as well, depending on regulatory costs. All three plans, however, suffer from a potentially severe moral hazard problem.
Full Text
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