Ratings Agencies, Public Policy and the Structure of Incentives

The recent debate over whether issuers or investors should pay ratings agencies totally misses the point. Both models create incentives for potential distortions of ratings behavior.

As many have pointed out, when issuers pay, there is a clear incentive to make the initial rating higher than it otherwise might be. No one would debate that.

However, the investor pays model creates incentives for distortions of ratings behavior which could be just as damaging. For instance, in an investor pays model, the initial ratings may be lower, on average. However, the ratings agencies would be incentivized not to downgrade debt. Doing so would create losses for bond investors. These same investors could steer business to ratings agencies which are more amenable to not downgrading debt.

Perhaps even more disturbing, as large institutions such as PIMCO or CALPERS would probably be paying among the highest fees in an investor pays model, there could be distortions in debt markets tied to their holdings, which may become statistically less likely to be downgraded. In such a scenario, the strategy of smaller players might be to imitate their portfolios, not because they are evil or dumb, but out of a rational urge to safeguard capital. The dangerous herd instinct of our capital markets would be further intensified and the very bubbles regulators are trying to stop could develop.

Bottom line, each model incentivizes distortions in behavior. This realization has led some to point out the salutary effect of competition. I would counter that it is precisely the urge to increase market share that has the effect of incentivizing raters to scrape the bottom of the barrel when rating debt. In a stable market share situation, with rational actors, there is no incentive to engage in ratings "grade inflation." The prospect of renewed competition incentivizes new competitors and established players such as S&P (MHP), Moody's (MCO), and Fitch to engage in product differentiation through ratings inflation. Certainly, new entrants cannot compete effectively on heritage, brand name, quality of databases, or the experience of personnel. In a situation in which firms essentially choose their regulator, the normal prescription of increased competition does not apply. It exacerbates the problem, and allows firms to pick the most lax ratings agency possible, from a wider menu of options--which is precisely what rational actors will do.

To be clear, all of the ratings agencies have made mistakes. I am merely trying to highlight the structure of incentives in the oft-proposed investor-pays model. I also own shares in MCO and MHP, so I am not a disinterested party. While we have had a healthy public debate about the issuer-pays model, I do not feel that the media, the ratings agencies, or regulators have given sufficient thought to the very real shortcomings of alternatives. All policy should be measured against the alternatives. Are we prepared to substitute one set of well-understood incentives, for another with wholly unexperienced effects? Are we prepared to exacerbate the incentive for ratings inflation with renewed competition that will only increase it?

Disclosure: Harry Long owns MCO shares directly, through partnerships, and through trusts. To the best of his knowledge, he and certain of his family members own MCO and MHP shares through partnerships and trusts. Such ownership may change at any time.

Comments

[BlueOkie:]

Ratings need to be totally relooked. Have a standard that all three majors use, instead of the different codes used by different firms. Also have different standards and ratings for different types of instruments e.g. bonds, stocks, corp instruments etc. I expect we'll have a company come out and score the rating agencies. I own MHP

Mar 29 01:32 PM

[Tjemme:]

My angle on this is that if we force more transparancy on risks by companies, we remove much of the value added of rating agencies.

Mar 29 01:44 PM

[Sahil Gujral:]

Investor pays v Issuers pays has been the way this issue has been largely framed. But it is a false choice. The ratings agencies should be free to choose whichever business model they find more appropriate in a free market. But the point is, it is not a free market. It is a government guaranteed rent, much like those we find in third world countries. It is basically, in this sense, un-American.

Since the enactment of SEC Rule 15c3-1, the Commission (inadvertently one hopes) made an already bad regulatory trend worse by enshrining and hardening the NRSRO designation. They did not merely give the NRSROs a rent-monopoly license. They gave them de facto regulatory and licensing powers. The FDIC might have meant well enough in the 30s when they began trying to use "private sector tools" to ensure the soundness of the banks. But the regulatory trend, culminating in 15c3-1's passage and its subsequent viral distribution throughout the world regulatory system, in the ensuing years was dangerously naive and anything but transparent.

To consider, if a bill were before the United States Congress, saying that Goldman Sachs research (or other consulting / sell-side firm's research) should be the governing standard of solvency for 80% of regulated financial players, does anyone doubt it would be laughed out of the chamber?

An analogy may be helpful. Consider garbage dumps.

Society produces large amounts of waste. Some of it is more toxic to the environment then others. More toxic waste requires
more expensive processing. But a waste management company does not necessarily get compensated for this extra processing.

Instead, it would be in the economic interest of waste
management companies (everything else equal) simply to process as much trash as it could as cheaply as it could, while charging the garbage-creators as much as it could for the "more dangerous garbage." But even if the most dangerous dumpers pay you the highest fees, there is no guarantee in such a model that would process it to proper environmental standards.

But this behavior, while possibly very profitable for the waste manages, would impose a tremendous social cost, one many orders of magnitude higher than their profits, on the entire communal ecosystem in which they did business. Beyond dirtying the aesthetic appeal of the area, their pollutants in the water and air could cause sickness or death, the worst kinds of waste could poison the soil, erode foundations of constructed edifices, and so forth.

The economic costs could be staggering.

In order to combat this issue, local and national regulators, ranging from municipal board to the Environmental Protection Agency, in cooperation with government-employed scientists, establish very clear and strict rules about processing requirements for different
compounds, toxicology standards, and so forth.

Note that this is a deeper analogy than it seems. Though science, like finance, may be potentially a very judgment laden discipline in pursuit of “accuracy,” public policy opts for clear rules over delegated judgments and it certainly does not delegate these judgments to any private sector actor.

While its toxicological and similar cut-offs may be at times overly “crass” or “conservative,” not taking into account complex extenuating circumstances or unduly imposing an economic cost on society than would be possible if the garbage dump was collectively owned, public policy sees this as a sensible approach in protecting the public interest from the potentially much larger costs of failed environmental protection.

Coarse standards that let some of the best environmental solutions to such dumps fall by the wayside are seen as superior to nuanced, biased, individual, profit-motivated judgments that have the potential to let the worst toxic waste in and "kill the children."

Now imagine a different scenario.

Imagine if instead of having “rule-driven” EPA regulations, the government saw fit to designate a private, for-profit set of “historically recognized” environmental consulting companies as the sole designators of whether a company or factory’s garbage needed to be processed by private waste managers and in what minimum amounts. Imagine further that these consulting firms were not paid by the communities in which they operated nor even by the private waste managers but actually by the very companies and factories whose garbage they were assigned to “rate.”

It would not be hard to see how these consulting firms might be inclined to adulterate their communities with improperly certified “toxic waste,” as it were. Nor would it be hard to see how, if very low-impact company’s garbage were given similar processing requirements to those of the worst polluters, but the market nevertheless recognized a differential and thus paid waste managers slightly more for taking on the worst pollution, a predictable “race to the bottom” would ensue among the waste managers jockeying to
manage the most toxic of all of these companies (former) assets.

Eventually, of course, the toxic waste would infect the communities badly enough that people would notice. Higher levels of cancer might occur, the beaches might begin to smell, and whatever else. The communities would be justifiably outraged. But who would they properly blame? The companies and factories that made this waste? The waste companies that managed it for them without sufficient prudence? The consulting firms that certified the most deadly waste as harmless? The regulatory institutions that conceived of the current system? Themselves? It’s a tough question.

It’s particularly harder in financial markets, where, unlike ecosystems, not everyone has to smell the air or drink the water every day. The groundswell can sneak up on the average town resident if it exists in the realm of LIBOR.

This is exactly what the NRSRO regulation has done. It has created a public social good, which it outsources the role of guardian and final determination of a series of private, for-profit actors, and it in turn mandates that nearly every registered financial institution place a price value on the information provided by these "guardians." But these guardians need not eat their own dog food in any way. They don't own the companies or bonds they rate. They aren't even paid by investors.

To say the 2006 Act has "opened" the process is a bit like arguing that because Nigeria now has a set of printed regulations for applying to get an import quote, the rent seeking is no longer a concern. Obviously, all that has changed is the ability of would-be Moodys/S&P/Fitch competitors to spend "irrrational" amounts of money on lobbyists and lawyers to get their own government rent license, so they too can have de facto regulatory powers.

To butcher Vince Lombardi, in the context of financial markets over the long term, information is not everything, it is the only thing.

Investors and traders of all sorts are nothing more, at the end of the day, than glorified fortune tellers. They do not produce, manufacture, service, or design anything, other than conceptual frameworks and ideas about the future. This system works ruthlessly and brilliantly well in allocating capital insofar as actors bear the full costs and gains of the information they themselves create and invest based on. That is, in so far as their predictions are correct.

But that is not what these idiotic NRSRO laws do. They allow a group of "independent consultants" to make pronouncements on securities that, by law, almost all non-accredit investor driven financial institutions (basically everyone except hedge funds) must pay attention to. And if they are wrong, investors and the public can't sue them (first amendment defense and all the other nonsense), they can't make them share in the downside, they can't even lower their fees...because investors aren't paying them.

This is Un-American. You don't have to be a genius to see what is going on. The reported revenue from Moody’s “structured finance” segment, the one that recklessly gave so many AAA ratings to ABS and CDO securities that are now worth mere cents on the dollars, grew from 38% of the company's total ratings revenue in 2000 to 50% of such revenue by 2007. I'm sure MCO's margins on these products were as good as for their ratings business overall if not better.

So what has happened is that, by intending to protect "widows and orphans" in America from the time of FDR, regulators have made a series of idiotic decisions, culminating in the SEC's NRSRO designation, that impose an incredibly, incredibly regressive tax on all Americans. That is, that hurts most the "widows and orphans" they supposedly were trying to protect. The ordinary taxpayers, retail depositors, money market fund holders, insurance customers, that are now on the hook for trillions and trillions of dollars of bad decisions and foul play.

The era of "outsourcing" FDIC/OCC/State insurance/Basel II/SEC judgment to these fat cat, rent seeking, regulatorily larded for profit NRSROs must end. They must be made to compete in the free market like any other information provider; much as they did for the first 70 years of their history.

If the magnitude of this crisis has not made that obvious, I do not know what can.

In the place of this "outsourced" regulatory laziness, needs to come the kinds of crass, rules-based, overly simplistic, overly conservative public policy guidelines America already follows in areas like bridge construction or environmental protection. The FDIC and the taxpayer should not be on the line for retail bank's stupid investments; people who choose to buy policies from insurance companies making anything less than the simplest investments should be clearly informed those companies might not be around to pay them when their claims come due.

If and when this happens, whatever the virtues of an issuer-paid model, in my judgement, no ratings agency will be able to survive by it long term. The "captive market" that emerged out of the Penn-Central bankruptcy will be gone. In it's place will come a more honest business model that rewards these consulting agencies largely for the quality of the research and work they do, much as was the case for most of their 70 year history before, and much as any other American would be expected to do if he or she wanted to be in the "consulting" or "research" business.

I own or have owned MCO and MHP too. I have no intention of ever being short. So perhaps writing this is contrary to my own financial interest. But as an American and a taxpayer, it is an ethical duty. The NRSRO mafia has finally gone too far.

Apr 24 09:37 PM