Wait, Don’t Shut Down the Rating Agencies Just Yet

What is the information content in a bond rating?

[su_pullquote]The problem with the private information is that it comes from the management of the firm, which of course has an interest in providing more good news than bad news. [/su_pullquote]

Ratings agencies have access to all of the financial information that the rest of us do – financial statements, past and present, analyst reports, industry analysis etc. In addition, they can ask for private information specifically related to default risk, which can then be used to finesse or modify the rating. The problem with the private information is that it comes from the management of the firm, which of course has an interest in providing more good news than bad news.

The simplest way to measure whether the market thinks there is information in a bond rating is to look at whether market prices of bonds change when their ratings are changed. The evidence there is mixed. While there is a consistent price change, with bond prices increasing (decreasing) on bond upgrades (downgrades), most of the price change seems to happen before the rating is changed. In other words, markets seem to anticipate ratings changes. That does not make ratings less useful but they are often lagged measures of default risk.

Is there a potential for conflict of interest in ratings?

Going back to the origins of ratings, it is clear that bond buyers should be the ones paying for the ratings and they do so now, albeit indirectly. Ratings agencies are compensated by the companies that are rated, which does create a conflict of interest, though the conflict is nowhere near as intense as some other conflicts that bedevil us (such as auditors who have consulting revenue from the companies they audit or investment banks operating as deal makers & advisors on M&A deals). The price paid by companies is a relatively small one (3-5 basis points of the size of the issue) and it is not as if companies that are down graded can pull up stakes and refuse to be rated. (Let’s face it. There are more ratings downgrades in a quarter than equity research analyst sell recommendations in a decade.) The price paid by companies is then passed on to bond buyers as a slightly higher interest rate on the bond.

There is a bigger potential for conflict of interest with mortgage backed securities and other bonds that are issued against pools of assets, not by companies by often by intermediaries.

There, Moody’s and S&P do have an interest in growing the market and attaching higher ratings does increase market growth, which increases future revenues and so on…

There is much talk now of changing this model but the alternatives are not that attractive. One is to charge a small tax on every bond sold, collect the proceeds in an entity (probably government run) which will then pay the costs to have all bonds rated. The question then becomes choosing the ratings agency (ies) to do the rating and the pricing mechanism (fixed price, auction). The other is to increase competition among ratings agencies, with the argument that competition will make them worry about getting rating right, though this would exacerbate the conflict of interest, at least in the short term.

What should we do going forward?

[su_pullquote align=”right”]Rather, I think ratings agencies were caught up in the mood of the moment, just as the rest of world was, where housing prices always went up, people had permanently stopped defaulting and recessions were a thing of the past.[/su_pullquote]

Before we pile on ratings agencies and blame them for our bond losses, we have to recognize that they were not the only ones to under estimate default risk. Most banks in developed markets made the same mistake, as is clear by the losses being written off on loan portfolios. Thus, I would not blame the ratings mistakes primarily on conflicts of interest or poorly trained ratings staff or some conspiracy theory too dastardly to behold. Rather, I think ratings agencies were caught up in the mood of the moment, just as the rest of world was, where housing prices always went up, people had permanently stopped defaulting and recessions were a thing of the past. In closing, my fear is that we will throw the baby out with the bath water and make radical changes in the ratings process. Having valued companies in markets with bond ratings and in markets without, I can tell you with absolute conviction that I would rather deal with lagged and flawed bond ratings than no bond ratings at all.

Aswath Damodaran is a Professor of Finance at the Stern School of Business at NYU.

This article was published originally on Musings on Markets.

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