Credit Credit- -Rating Shopping, Selection and Rating Shopping, - PowerPoint PPT Presentation

“Credit Credit- -Rating Shopping, Selection and Rating Shopping, Selection and “ the Equilibrium Structure of Ratings” ” the Equilibrium Structure of Ratings Francesco Sangiorgi Francesco Sangiorgi Stockholm School of Economics Stockholm School of Economics Jonathan Sokobin Jonathan Sokobin Securities and Exchange Commission Securities and Exchange Commission Chester S. Chester S. Spatt Spatt Tepper School of Business School of Business Tepper Carnegie Mellon University and Carnegie Mellon University and National Bureau of Economic Research National Bureau of Economic Research 2 0 0 9 UBC Sum m er Finance Conference 2 0 0 9 UBC Sum m er Finance Conference W estbank , British Colum bia W estbank , British Colum bia July 28, 2009 July 28, 2009 1 1 1 1

Selling Information Selling Information   “ Investor pays Investor pays” ” model model “   Conflicts of interest (limited) Conflicts of interest (limited)   Difficulty of exclusion Difficulty of exclusion   Availability of ratings and regulation Availability of ratings and regulation   “Issuer/ “ Issuer/Securitizer Securitizer pays pays” ” model model   Conflicts of interest (extensive)— —Ratings shopping for individual Ratings shopping for individual Conflicts of interest (extensive) transactions, but also positive views about securitization and tranching tranching transactions, but also positive views about securitization and   Limited incentive for re- -rating rating Limited incentive for re   Issuer chooses which ratings to purchase, publish Issuer chooses which ratings to purchase, publish 2 2 2 2

Demand for High Ratings Demand for High Ratings Information and asset demand Information and asset demand Net capital rules Net capital rules Money market funds; permissible holdings Money market funds; permissible holdings “Investment grade Investment grade” ” and suitability and suitability “ Purchase from agency offering the highest rating Purchase from agency offering the highest rating If multiple ratings at a level required, then nth- -order statistic key order statistic key If multiple ratings at a level required, then nth Manufacturing rating, structuring (“ “regulatory arbitrage regulatory arbitrage” ”) )— —AAA AAA Manufacturing rating, structuring ( meaning very distorted (corporate bonds vs. municipals too) meaning very distorted (corporate bonds vs. municipals too) 3 3 3 3

Spotlight on Credit Rating Agencies Scope to mis-value an entire asset class rather than specific loans Potential for systemic risk as investors relied upon CRAs While reputation weakened, investors and regulators look to CRAs Conflict of interest and the payment model – “Selection” and rating shopping Outsourcing due diligence (especially to few players) is an odd basis for asset management, despite scale economies – creating diverse signals Move towards reduced regulatory reliance on ratings 4 4

Related Regulatory Proposals Related Regulatory Proposals What factors were considered by the rating agency? What factors were considered by the rating agency? What was the basis of the ratings? What was the basis of the ratings? – Especially important for structured financing (encourage Especially important for structured financing (encourage – unsolicited ratings) unsolicited ratings) Track record disclosure Track record disclosure (Reputation is apparently not powerful enough to force above (Reputation is apparently not powerful enough to force above disclosures) disclosures) 5 5 5 5

Reduced Regulatory Reliance on Ratings ?? Reduced Regulatory Reliance on Ratings ?? – Mitigate systemic risk (mis mis- -value an asset class) value an asset class) – Mitigate systemic risk ( – – Avoids allowing agencies to sell regulation and amplifies Avoids allowing agencies to sell regulation and amplifies conflict of interest conflict of interest – Ratings for different products have different meanings-- --reduce reduce – Ratings for different products have different meanings effort to engage in “ effort to engage in “regulatory arbitrage regulatory arbitrage” ” – Encourages decentralized and competing due diligence – Encourages decentralized and competing due diligence – ”Dead on Arrival Dead on Arrival” ”: Asset managers like current legal safe : Asset managers like current legal safe – ” harbors harbors 6 6

Economics of Selection and Regulation “Selection” theme Solicited vs. unsolicited ratings “Notching” Comparative statics of cost, correlation and transparency Extension to “winner’s curse” 7 7

Solicited vs. Unsolicited Ratings Solicited vs. Unsolicited Ratings Solicited— —Issuer purchases Issuer purchases Solicited Unsolicited is voluntary choice of agency Unsolicited is voluntary choice of agency – Difficult for securitization Difficult for securitization – – Regulators discouraged this for several years (were Regulators discouraged this for several years (were – unsolicited ratings punitive?), now trying to promote to unsolicited ratings punitive?), now trying to promote to limit conflicts of interest from solicited ratings— limit conflicts of interest from solicited ratings —example example of “ “ unintended consequences unintended consequences” ” and regulation and regulation of – “ “ Conflicts of interest Conflicts of interest ” ” and the analogy to and the analogy to “ “ second second- - best best ” ” – frictions (should we shut down individual frictions?) frictions (should we shut down individual frictions?) Due to unsolicited ratings hard to charge (incentive Due to unsolicited ratings hard to charge (incentive constraint) for solicited ones— —unless unsolicited ratings unless unsolicited ratings constraint) for solicited ones tend to be lower tend to be lower – Otherwise, no incentive to purchase rating Otherwise, no incentive to purchase rating – 8 8

Why are Unsolicited Ratings Lower than Why are Unsolicited Ratings Lower than Solicited Ones? Solicited Ones? Otherwise, no incentive to purchase rating Otherwise, no incentive to purchase rating Motive need not be punitive Motive need not be punitive Selection story— —Solicited ratings have access to fine details Solicited ratings have access to fine details Selection story – Firms for which that would be beneficial net of cost will pay fo – Firms for which that would be beneficial net of cost will pay for a rating r a rating Are unsolicited ratings artificially low or solicited ratings artificially tificially Are unsolicited ratings artificially low or solicited ratings ar high due to ratings shopping? high due to ratings shopping? Which is the important conflict of interest? Which is the important conflict of interest? 9 9 9 9

Why are Unsolicited Ratings Lower than Why are Unsolicited Ratings Lower than Solicited Ones? (cont.) Solicited Ones? (cont.) Unsolicited rating if firm’ ’s estimate is below s estimate is below x x * and solicit if estimate * and solicit if estimate Unsolicited rating if firm exceeds x x *. Optimal *. Optimal x x * is determined by ratings cost. * is determined by ratings cost. exceeds a b X* (If cost = 0, then x (If cost = 0, then x * = 0 as in * = 0 as in Akerlof Akerlof [1970]) [1970]) Under ratings shopping firms have choice of which agency or Under ratings shopping firms have choice of which agency or agencies to solicit— —reinforces the effect reinforces the effect agencies to solicit Multiple agencies extend the Verrecchia Multiple agencies extend the Verrecchia [1983] disclosure intuition [1983] disclosure intuition 10 10 10 10

Selectivity Framework Selectivity Framework Agency i possesses own signal about distribution of one- -period period Agency i possesses own signal about distribution of one payoff, f f i payoff, i -- simplified view of a rating -- simplified view of a rating Role of signal is to classify asset for regulatory objectives Role of signal is to classify asset for regulatory objectives – each agency treated equivalently each agency treated equivalently – – high ratings desired to minimize need for regulatory capital high ratings desired to minimize need for regulatory capital – Diverse models, common knowledge Diverse models, common knowledge Goal is to maximize NPV of the issuer Goal is to maximize NPV of the issuer 11 11 11 11