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Why U.S. Financial Markets Need a Public Credit Rating Agency M Why U.S. Financial Markets Need a Public Credit Rating Agency M. AHmeD DIOmanDE, James HeIntZ anD RObert POLLIN he major private credit rating of assets that either carried high, or at the very perverse incentive system that distorts the agencies—Moody’s, Standard & least, highly uncertain risks. work of private agencies. Poors, and Fitch—were significant Moreover, the reason these agencies contributors in creating the housing consistently understated risks was not sim- PERVERSE INCENTIVES FOR PRIVATE AGENCIES bubble and subsequent financial ply that they were relying on economic theo- ith the benefit of hindsight, the Tcrash of 2007–08. The rating agencies are sup- ries that underplay the role of systemic risk Wmisjudgments of the agencies are now posed to be in the business of providing financial in guiding their appraisals, though this was widely recognized. The economics journalist markets with objective and accurate appraisals an important factor. The more significant in- Roger Lowenstein offered this appraisal in the as to the risks associated with purchasing any fluences were market incentives themselves, The New York Times: given financial instrument. Instead, they consis- which pushed the agencies toward providing tently delivered overly optimistic assessments overly favorable appraisals. Giving favorable Over the last decade, Moody’s and its two risk appraisals was good for the rating agen- principal competitors, Standard & Poor’s cies’ own bottom line, and the rating agen- and Fitch, … [put] what amounted to M. Ahmed Diomande is Secretary, New York State Senate Finance Committee; James Heintz is an Associate Professor cies responded in the expected way to these gold seals on mortgage securities that at the Political Economy Research Institute (PERI) at the available opportunities. The most effective investors swept up with increasing élan. University of Massachusetts, Amherst; Robert Pollin is a Professor of Economics and co-director of PERI at the solution would be to create a public credit For the rating agencies, this business University of Massachusetts, Amherst. rating agency that operates free of the same was extremely lucrative. Their profits © The Berkeley Electronic Press The Economists’ Voice www.bepress.com/ev June 2009 -1- surged … But who was evaluating these spread for the same $10 million bond to $3 how companies will select a rating agency. securities? Who was passing judgment million. The agencies therefore lean as much as possible on the quality of the mortgages, on the In principle, the incentives in the toward providing favorable ratings. equity behind them and on myriad other marketplace are supposed to operate to push investment considerations? Certainly the agencies toward providing objective and PUBLIC CREDIT AGENCY AS CORRECTIVE not the investors. They relied on a credit accurate appraisals since, in principle, the only he fundamental contribution of a public rating (4/27/08). valuable product the agencies are offering in Tcredit rating agency would be to offer a the marketplace is their credibility. As such, if counterforce to the perverse incentive system Of course, the reason investors “relied on an agency is failing to provide the market with facing private agencies. It is true that provid- a credit rating” is that they assumed the rating credible information, one would expect they ing accurate risk appraisals has become in- agencies were committed to providing objec- would be punished in the market—market creasingly challenging as securitized markets tive and accurate risk appraisals. Indeed, the competition should drive out the incompe- have deepened. There may well be situations in evaluations provided by the agencies are the tent firms and reward those that are indeed which the staff of the public agency concludes basis for how investors price assets, which in providing credible information. that an instrument is too complex to provide turn has a major impact on how investment In fact, however, a large gap exists between an accurate risk appraisal. In such situations, projects get financed, or even whether or not this ideal set of incentives that should guide it would be the obligation of the public agency they get off the ground. For example, on aver- the activities of credit rating agencies and the to be open with such an assessment—that is, to age between 1950–2007, a bond that was rat- actual incentives they face. In practice, the rea- assess an instrument as “not ratable.” Financial ed as AAA by Moody’s paid out an interest rate son the rating agencies operate with a strong market participants could then decide the de- that was almost one percentage point below a bias to provide favorable ratings on financial gree to which they might wish to take a gamble BAA rated bond. If, for example, a $10 million instruments is simple: the agencies are hired by with such an instrument. bond has a maturity of 10 years, this interest the companies that they are evaluating. Com- The public credit rating agency operating rate differential amounts to a $1 million dif- panies therefore choose to hire agencies that in this way would dramatically change the in- ference in debt servicing. In the midst of the they think are more likely to provide favorable centives for the private rating agencies as well 2008 financial crisis, the spread between AAA ratings, which in turn enhances the compa- as the broader array of financial market par- and BAA bonds rose to almost three percent- nies’ ability to sell their financial instruments. ticipants. It would weaken the biases in favor age points, thus increasing the debt servicing The agencies, in turn, recognize this bias in of greater risk and complexity, and move the The Economists’ Voice www.bepress.com/ev June 2009 -2- financial system to operate with a higher level The new agency could be organized to direct the day-to-day activities of the ratings of transparency. The private agencies would be operate through procedures that borrow from agency. They would remain accountable to free to continue operating as they wish. But existing regulatory agencies, including the Congress, including through providing annual when their appraisals differ significantly from Food and Drug Administration and the Secu- public reports on their operations. those provided by the public agency, the pri- rities and Exchange Commission. Just as the Similar to the SEC, which is financed vate agencies would be forced to explain the FDA assesses health risks associated with new largely through a low-level securities trans- basis for their divergent assessments. pharmaceuticals before the drugs can be mar- actions tax and registration fees, the public Market participants would thus be free to keted, the public ratings agency would assess ratings agency could be financed by cost-re- evaluate the full range of information and as- the riskiness of financial assets before the se- covery fees. Any surplus generated would be sessments available to them, from the public curities could be publicly traded. Unlike the taxed at an effective rate of 100 percent and agency, the private agencies, and elsewhere. It FDA, the public rating agency would not have transferred to the Treasury. This would re- is useful to recall that in the 1980s, Michael the authority to prevent securities from being move any incentives to manipulate ratings so Milken of the now defunct firm Drexel Burn- marketed, but only to offer their independent as to increase revenues above cost but would ham Lambert created the “junk bond” market risk assessment. also create a sustainable pool of finance to precisely by insisting that the traditional rating Like the SEC, the agency would perform cover the costs of generating reliable public agencies were overly cautious in their apprais- most effectively operating as much as possible financial information. als of corporate bonds. Market participants at arm’s length from political influences. To The staff of the public agency would be could make comparable assessments on their create a relatively autonomous operating space compensated as high-level civil servants. They own with respect to the appraisals of the public for the agency, we propose that one third of the would receive no benefits as such from pro- rating agencies. agency’s Governors—of perhaps 12 Governors viding either favorable or unfavorable rat- in total—would be nominated, respectively, by ings. Indeed, a compensation system could be HOW THE AGENCY COULD OPERATE the House Financial Services Committee, the established whereby the professional staff is e propose that all private businesses Senate Finance Committee, and the President. evaluated on the basis how well their risk as- Wissuing securities that are to be traded Nominees would then be subject to Congres- sessments of given assets end up comporting publicly in U.S. financial markets would be re- sional approval, following standard procedures with the market performance of these assets quired to obtain a rating by the public agency such as those already in place for SEC or Fed- over time. Safeguards would be put in place before any trading could be conducted legally. eral Reserve governors. The Governors would to dismiss any professional staff members The Economists’ Voice www.bepress.com/ev June 2009 -3- who have conflicts of interest that could Crouhy, Michel G., Robert A. Jarrow, and Stu- Reform Act of 2006.” Available at: http://www. compromise the integrity of their ratings. art M. Turnbull (2008) “The subprime crisis of govtrack.us/congress/bill.xpd?bill=s109-3850. Amid the most severe economic down- 2007,” Journal of Derivatives, 16(1): 81–110. turn since the 1930s Depression, we face a Lucas, Douglas L., Laurie S. Goodman, and massive long-term project of rebuilding a Frank J. Fabozzi (2008) “How to save the financial system that is capable of support- ratings agencies,” Journal of Structured Fi- ing a stable and equitable growth path for the nance, 14(2): 21–26.
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