S&P, Moody’s, Fitch, and the other credit rating agencies analyze fixed income securities to categorize them by probability of default. Their ratings reduce the risk of rated securities by increasing investor knowledge and thereby acting as a standard in the capital market supply chain.
Yet the rating agencies have an inherent conflict of interest. They’re paid by the firms that they’re supposed to be objectively analyzing. The creditor firms can shop around for the highest rating, incentivizing the rating agencies to improperly inflate ratings to attract customers and win market share.
Everyone knows this. Steve Carell learned it in The Big Short when he tried to confront S&P about their ratings and the representative told him that if they don’t give out high ratings then their customers will take their business to Moody’s.
The Wall Street Journal frequently reminds its readers. They published an investigation in August that showed “S&P and its competitors are giving increasingly optimistic ratings as they fight for market share.”
WSJ journalist Cezary Podkul was on CNBC to explain:
Mathisen: Is the problem as acute as it was pre-financial crisis? A lot of people, as we said in the introduction, thought this was a problem that had been hosed out of the system. But clearly it hasn’t.
Podkul: No because it’s the same business model. The main thing that congress didn’t change after the financial crisis is they said, ‘hey issuers, you can still pay for the ratings.’ And so that gives them leverage to decide who to pick. And, of course, they have an incentive to pick the best ratings. So because that wasn’t fixed, that whole dynamic is still there.”
Elizabeth Warren smelled blood in the water. She sent a letter to the SEC in September demanding to know why they haven’t forced the agencies to change from the ‘issuer-pays model’ to the ‘subscriber-pays model’.
In the subscriber-pays model, investors pay the rating agencies for the ratings. Supposedly, a subscriber-pays model will solve the conflict of interest because creditors no longer have the opportunity to shop around for ratings.
Yet even in this new structure the industry would run into the same problem. Matt Levine at Bloomberg makes the point:
“Surely sometimes the ratings firm would decide that a bond was a double-B, and some big asset manager would call it and say “we really like that bond and we want to put it in our investment-grade fund, can you make it a triple-B?” They might not say it like that; they might make a credit argument instead (presumably they like the bond because they think it’s a good credit!), or they might just go shop for a better rating from a different ratings firm.”
Alignment of Interest
Maybe the problem is not with the agencies’ business model but with how people think about the business model.
Does the credit supply chain above look different than any other supply chain?
The same argument about a conflict of interest applies to car companies. The automotive OEM can shop around for the seatbelts that go into its car. The OEM wants the lowest priced seatbelt and thus seatbelt suppliers are incentivized to offer the cheapest, lowest quality seatbelts to gain market share. This dangerous conflict of interest will result in seatbelts made of tissue paper!
Why doesn’t this happen? Because the OEM doesn’t want the cheapest, lowest quality seatbelts- it wants the seatbelts that have the highest net value to the customer.
The only reason that seatbelts have value to the OEM is because they have value to the dealer. And the only reason they have value to the dealer is because they have value to the car owner. The same is true of credit ratings.
The creditor doesn’t want the highest credit rating on their debt as Podkul claims- it wants the credit rating that has the highest net value to the investor and thus most lowers the cost of its debt. The only reason that credit ratings have value to creditors is because they have value to asset managers. And the only reason that the ratings have value to asset managers is because they have value to individual investors who benefit from the proper classification of their investments’ risks.
What you might expect to happen in a properly functioning market is that inflated ratings are less valuable to the investor, and thus less valuable to the creditor.
That is exactly what the WSJ reports: “Some bonds in markets where ratings criteria have been eased don’t trade at the high bond prices their ratings suggest they should. Investors have also shown skepticism about ratings on some corporate and government bonds.”
This is one reason why it’s hard for competitors to take market share in this industry. You can’t simply lower the quality of your product and vacuum up market share.
Conflicts of Interest
Of course, a well trusted rating agency could inflate ratings to gain market share before investors realize what they are doing. A rating agency could spend its reputational capital for short term gain just like an insurance company can grow tremendously by selling unprofitable insurance. It turns out that short-term profits at the expense of your long-term business is an impractical strategy for making money. Every business that tries it arrives at the long-term part of the equation. We should be glad that Elizabeth Warren isn’t in charge of strategy at one of the agencies.
In essence, the arguments against the rating agency business model amount to: ‘it’s possible for an agency to do something that’s profitable in the short run but disastrous in the long run’. But that’s true of every choice in life. That’s why it’s possible to invent a ‘conflict of interest’ in any business model that’s dreamed up.
Everyone has a thousand opportunities a day to make choices with short term payoffs and awful long-term consequences, but we properly conceptualize those as ‘self-destructive’. You don’t face a conflict of interest between saving for retirement and blowing your savings on drugs for momentary enjoyment.
Yet people often make decisions that sacrifice the long run for immediate gratification. Some people do steal, or lie to their significant other, or whatever. Suppose you didn’t want someone to engage in self-destructive behavior. Would you frequently remind them that the behavior is in their interest?