the credit ratings game - kif.re.kr freixas ppt.pdf · the credit ratings game bolton, freixas, and...

The CreditRatings Game

Bolton,Freixas, andShapiro

Introduction

MonopolyCRA

Duopoly

Welfare

Regulation

Regulatoryreform

Conclusions

The Credit Ratings Game

Patrick Bolton, Xavier Freixas, and Joel Shapiro



Introduction

MonopolyCRA

Duopoly

Welfare

Regulation

Regulatoryreform

Conclusions

The Subprime Crisis

Dollar value of originations of subprime mortgages rosefrom $65 billion in 1995 to $600 billion in 2006

Moody�s pro�ts tripled between 2002 and 2006, withpro�t margins of 50%

Income from rating structured deals amounted to 50% ofCRA total income

Extreme complexity of ABS, CDOs (Gorton, 2009)



Introduction

MonopolyCRA

Duopoly

Welfare

Regulation

Regulatoryreform

Conclusions

Key Elements of the Credit Rating Industry

Issuer pays, and payments may in�uence ratings:

Fees are renegotiated with regular clients.

Analytical managers participated in fee discussions withissuers and sta¤ discussed fees and market share (SEC)

CRAs o¤er related consulting services, such as pre-ratingassessments

Possible con�icts of interest

Issuers shop for ratings:

rating agencies are only paid if the credit rating is issued

"What the market doesn�t know is who�s seen certaintransactions but wasn�t hired to rate those deals" - BrianClarkson, president and COO (until July 2008), Moody�s



Introduction

MonopolyCRA

Duopoly

Welfare

Regulation

Regulatoryreform

Conclusions

Agencies�models are not precise:

Errors have been detected (and abused as in ABACUS)

agencies do not perform due dilligence on issuer data

Large barriers to entry exist:

SEC prohibited entry by creating NRSRO (NationallyRecognized Statiscally Rating Organization) designation

Reputation plays a role in decisionmaking :

agencies state that their business is dependent on marketcon�dence



Introduction

MonopolyCRA

Duopoly

Welfare

Regulation

Regulatoryreform

Conclusions

Motivation

Understand the con�icts of interest characteristic of creditrating agencies

Consider the e¢ ciency issues

Derive the pros and cons of three di¤erent plans to reformthe industry



Introduction

MonopolyCRA

Duopoly

Welfare

Regulation

Regulatoryreform

Conclusions

This paper

We incorporate these elements in a model of how CreditRatings Agencies (CRAs) manage con�icts of interest andwe examine proposed regulations of the industry.

Our �ndings:

For the same information revelation strategy duopoly isless e¢ cient than monopoly in terms of both total ex-antesurplus and consumer surplusMore precise information increases current payo¤s, but alsoincreases the probability of getting caught.The most e¢ cient solution is to change to a system ofupfront fees, automatic disclosure of ratings, and oversighton analytical standards



Introduction

MonopolyCRA

Duopoly

Welfare

Regulation

Regulatoryreform

Conclusions

Roadmap

Literature Review

Monopoly

Duopoly

Welfare

Regulation

Conclusion



Introduction

MonopolyCRA

Duopoly

Welfare

Regulation

Regulatoryreform

Conclusions

Related Literature

Certi�cation intermediaries: Biglaiser (1993)

Sobel (1985), Benabou and Laroque (1992)communication strategies

Certi�cation intermediaries with endogenous lying costs:Strausz (2005) Mathis, McAndrews and Rochet (2008)

Certi�cation intermediaries with exogenous lying costs:Bolton, Freixas, and Shapiro (2007)

Transparency of a screening process: Farhi, Lerner, andTirole (2008), Pagano and Volpin (2009)

Shopping: Skreta and Veldkamp (2008), Sangiorgi etal.(2010)

Empirical results: Becker and Milbourn (2008)



Introduction

MonopolyCRA

Duopoly

Welfare

Regulation

Regulatoryreform

Conclusions

The Model

Three players: Issuer, Credit Rating Agency, InvestorsAn Investment: ex-ante is of type g with probability 1

2 , botherwiseProb (g defaults)=0, Prob (b defaults)=pReturns R when not defaulting, r when defaultingCRA gets a private signal θ 2 fg , bg about the true stateω:

Pr(θ = g j ω = g) = Pr(θ = b j ω = b) = e

Pr(θ = g j ω = b) = Pr(θ = b j ω = g) = 1� e

e measures the precision of the signal (known)

Fees can be set conditional on report of CRA: φm , wherem = G ,B.



Introduction

MonopolyCRA

Duopoly

Welfare

Regulation

Regulatoryreform

Conclusions

Investment technology

W=g

R

W=b

R

rp

1p



Introduction

MonopolyCRA

Duopoly

Welfare

Regulation

Regulatoryreform

Conclusions

Signalling strategy: bad state of nature

g

b

W=b

Signal

e

1e

G

B

G

B

p

1p

p

1p

p

1p

p

1p

R

r

R

r

R

r

R

r



Introduction

MonopolyCRA

Duopoly

Welfare

Regulation

Regulatoryreform

Conclusions

After observing the report, the issuer can purchase it, orrefuse to purchase it (shopping).

Once the rating is announced (or not), the issuer sets auniform price T

Investors can be sophisticated (1� α) or naive (α)

We assume exogenous reputation costs: in the event of adefault after a good rating, investors �nd out whether theCRA lied and punish by withdrawing their business.

Discounted sum of future pro�ts= ρ

Assumption A0: There is a tiny amount of uncertainty onthe part of the CRA about the actual value of ρ, i.e.ρ 2 [ρ̃� ε, ρ̃+ ε] such that ε ! 0. This uncertainty isresolved when the CRA receives its signal.



Introduction

MonopolyCRA

Duopoly

Welfare

Regulation

Regulatoryreform

Conclusions

Investors are risk neutral and purchase 0, 1 or 2 unitsReservation utility: u on the �rst unit and U on thesecond unit, where U > uCuto¤ p� is de�ned by the indi¤erence condition:

(1� p�)R + p�r = U.Also:

(A1) (1� p)R + pr > u

(A2) (1� e)p < p�

(A3)p2> p�



Introduction

MonopolyCRA

Duopoly

Welfare

Regulation

Regulatoryreform

Conclusions

Timing

1 The CRA posts its fee of φm , where m = G ,B.

2 The issuer asks for the signal to be retrieved or not.

3 Given a request by the issuer, the CRA receives the signaland then makes a report of m = G or m = B,

4 The issuer observes the report and decides whether to buyand distribute it or not. The issuer then sets a price T fora unit of the investment.

5 Investors observe the price T and the CRA rating if thereis any and decide how much of the investment to purchase.

6 The return is realized.



Introduction

MonopolyCRA

Duopoly

Welfare

Regulation

Regulatoryreform

Conclusions

Notation

V 0 =Value of the investment absent any (credible)informationV G =Value of the investment if g is obtained and truthfullyannounced G=gV B =Value of the investment if b is obtained and truthfullyannounced B=b



Introduction

MonopolyCRA

Duopoly

Welfare

Regulation

Regulatoryreform

Conclusions

Information Regimes

Lemma

For a given set of fees φm , the CRA�s reporting strategy is:

1 For φG � φB > epρ, the CRA always reports �G�

2 For 0 < φG � φB < epρ, the CRA reports the truth,relaying its signal perfectly.

3 For φG � φB < 0, the CRA always reports �B�

Lemma

The issuer never buys a m = B report. This implies that theCRA�s actual reporting strategy is:

1 For φG > epρ, the CRA always reports m = G, and

2 For 0 < φG < epρ, the CRA reports the truth, relaying itssignal perfectly.



Introduction

MonopolyCRA

Duopoly

Welfare

Regulation

Regulatoryreform

Conclusions

Equilibrium Fees

Proposition

There are two equilibria of the fee setting game:

1 If α2V G � V 0 > epρ, the CRA sets φG = α2V G � V 0,always reports m = G, and has pro�ts

α2V G � V 0 + (1� ep2)ρ,

2 If α2V G � V 0 < epρ, the CRA setsφG = min[2V G +max[αV 0,V B ]� 2V 0, epρ], reportstruthfully, and has pro�ts

12min[2V G +max[αV 0,V B ]� 2V 0, epρ] + ρ.



Introduction

MonopolyCRA

Duopoly

Welfare

Regulation

Regulatoryreform

Conclusions

The cuto¤ α2V G � V 0 � epρ determines which informationregime prevails

Low reputation costs or many naive investors makeoverstating more likely

Low p makes overstating more likely. This could be relatedto the business cycle.

Higher precision means higher current pro�ts, but morelikely to get caught

In truthtelling, fees are bounded above by expectedreputation costs



Introduction

MonopolyCRA

Duopoly

Welfare

Regulation

Regulatoryreform

Conclusions

Two CRAs

Game has same structure, fees are posted simultaneously

De�ne V GG ,V BB

Extra assumption:

(A4) α2V G � V 0 > 2(V GG � V G )

The discounted sum of future pro�ts for each CRA notcaught lying is ρD

Information regimes are the same as before



Introduction

MonopolyCRA

Duopoly

Welfare

Regulation

Regulatoryreform

Conclusions

Equilibrium Fees

Proposition

The Nash equilibrium of the fee setting subgame is:

1 If α2(V GG � V G ) > epρD , both CRAs always report G

2 If α2(V GG � V G ) < epρD , both CRAs report truthfully,and

1 If α 2 [32V

0

2V G , 1], the issuer hires both CRAs

2 If α 2 [ V 02V G ,32V

0

2V G ), the issuer only hires one CRA and

φRk = φIk = 0, k = 1, 2



Introduction

MonopolyCRA

Duopoly

Welfare

Regulation

Regulatoryreform

Conclusions

Results - Two CRAs vs. One CRA

The cuto¤ α2(V GG � V G )� epρD determines which regimethe CRAs are in

Current payo¤s are larger with one CRA, but so are futurecosts if ρ � ρD



Introduction

MonopolyCRA

Duopoly

Welfare

Regulation

Regulatoryreform

Conclusions

Total Ex-Ante Surplus

Proposition

A truthtelling duopoly (when both CRAs are hired) is lesse¢ cient than a truthtelling monopoly.

Moreover, TS is the same in monopoly or duopoly whenthe CRA(s) always report G

Proposition is the same for Investor Surplus. IS is strictlylarger in monopoly when the CRA(s) always report G



Introduction

MonopolyCRA

Duopoly

Welfare

Regulation

Regulatoryreform

Conclusions

RegulationThe Cuomo Plan

Issuers must pay CRAs upfront (not conditional on thereport)

With one or two CRAs: selects the truthtelling regime ofthe model

Eliminating shopping from the Cuomo plan

Two CRAs: Issuer only purchases one report and CRA feesare zero.



Introduction

MonopolyCRA

Duopoly

Welfare

Regulation

Regulatoryreform

Conclusions

RegulationAn Investor�s Pay Solution

Investor�s pay system disappeared because of free-ridingproblem in the early 1970s.

It could be re-established through taxation (of investors orissuers).

If this prohibited shopping, it could be as good as theCuomo plan without shopping.

However, there are additional regulatory costs: choosingthe optimal tax, monitoring CRA performance andchoosing how many CRAs are active.



Introduction

MonopolyCRA

Duopoly

Welfare

Regulation

Regulatoryreform

Conclusions

RegulationMoral Hazard

If precision e is chosen by the CRA after receiving paymentsand is non-contractible, the CRAs would choose the minimumprecision in all three regulatory plans.In the main model, the CRAs would choose an e > 1

2Therefore, these plans would need oversight of minimumanalytical standards



Introduction

MonopolyCRA

Duopoly

Welfare

Regulation

Regulatoryreform

Conclusions

Regulatory reform

Dodd Frank Act Committee�More independent directors for CRAs, penalties and Internal�rewalls reduce con�icts of interest�The Franken amendment also addresses shoppingGlobal Financial Stability 10 Recommendations�Improve market discipline by improving information



Introduction

MonopolyCRA

Duopoly

Welfare

Regulation

Regulatoryreform

Conclusions

Conclusions

Higher pro�ts, more naive investors and lower reputationcosts foster in�ation rating

One CRA can be better than two in terms of TS and ISdue to shopping

Prohibiting shopping from Cuomo plan is optimal, butneed to monitor analytical quality

Restructuring reduces surplus

the credit ratings game - kif.re.kr freixas ppt.pdf · the credit ratings game bolton, freixas, and...

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