case for a parallel ratings agency

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1 | Rating a Lemon in the Market

January 31, 2011 Maxens Berre Knowledge House Maastricht

The Case for a Parallel Rating Agency: Rating a Lemon in the Financial Market

Abstract

This paper offers an explanation for the 2008-2009 financial crisis using an adverse selection model for

the asset-backed security and collateralized debt obligation markets, in which more than 90% of assets

enjoyed a AAA rating despite being based on sub-prime real-estate lending. Because the classical

adverse selection incentive-alignment response would be ineffective during episodes of bankruptcy in

the financial markets, alternate arrangements for incentive-alignment are necessary. A public-sector

rating agency would align the incentives of private-sector credit-rating agencies via a reputation effect.

This public agency would in-turn maintain its integrity and neutrality via central-bank-style policy

independence architecture.

Keywords: Adverse Selection, Credit Rating Agency, Financial Markets, Policy Independence, Conflict of

Interest, Financial Crisis





Introduction

In the US the 2008-2009 financial crisis began as the bursting of a bubble in the real-estate market.

Securities based on sub-prime mortgages, which had found their way onto the balance sheets of

investment banks all over the world started to drop in value as the underlying mortgages dropped in

value. These mortgages decreased in value because both the likelihood that they would be paid off declined with the housing market and because the real-estate which these mortgages were based on

also dropped in value. Overnight, investors across the world dumped their mortgage-derived and

collateralized securities, causing their value to evaporate almost instantly.1

The general consensus is that this crisis began with the mis-pricing of risk.2

A primary contributing factor

to this mis-pricing was the widespread information asymmetry in the financial markets of the major

OECD economies. The initial tremors of the crisis can be traced back to the trade of collateralized debt

obligations (CDO) and asset-backed securities (ABS), which were trading as AAA-rated securities.

Essentially, toxic assets were traded globally under ratings which later proved to be wildly misleading.

This enabled origination of loans without regard to their soundness or sustainability, hoping only to sell

to a greater fool in a global game of hot potato. US lenders originated and world markets bought.

Underlying the entire housing bubble was senior AAA given to an unrealistically large share of

collateralized debt obligations (CDO) and asset-backed securities (ABS). Because most mezzanine

tranche, speculation-grade collateralized debt was recycled into AAA-rated CDO-squared, around 90% of

securities derived from sub-prime lending enjoyed AAA rating regardless of how risky the underlying

assets actually were.

3

This came despite the inherent instability of sub-prime real-estate debt.

4

1Skidelsky, R., 2010

2Ibid

3International Monetary Fund, 2008

4Ibid





One might ask how exactly it occurred that safe ratings were awarded to such a high proportion of

assets in this sector. This market failure, in a nutshell, can be summarized as one of conflicts of interest

and broken incentives.5 Specifically, rating agencies who are remunerated by the party issuing the

securities, who in turn has a clear and unmistakable interest in seeing the securities enter the market

with the most secure rating possible. Since rating agencies are private, for-profit companies, with the

obligation to maximize shareholder value there exists the very real risk of rating agencies assigning

unrealistically secure ratings in order to reach this end.

Adverse Selection: The Market for Lemons

In the view of economic theory, the situation can be best described as an Adverse Selection model,

more commonly known as a Market for Lemons. In the classical Akerlof Adverse Selection model, the

used car salesman is paid a commission by her dealership to sell used cars. Thus, her incentive is aligned

to that of the dealership for which she works. She can maximize her income by overstating the value of

the cars, making them more attractive to the market, thus increasing her commission. While the car

dealership and the salesman together constitute the agent, the buyers’ market is the principal who is

misled by the information asymmetry.

In Akerlof ’s model, the amount consumers are willing to pay for automobiles declines as they realize the

average true value of the used cars. This in turn, drives the average quality down further as good cars

are driven out of the market by the bad cars. This occurs presumably because the legitimate sellers

whose automobile prices accurately reflect quality simply cannot compete in terms of profitability and

cost with dishonest traders and are simply priced out of the market. Ultimately, the market for used carscollapses, and there is only demand for cars which are clearly absolutely at the bottom of the market in

terms of their intrinsic value.6

The story of Adverse Selection in the financial markets is similar. While the buyers’ market for rated

financial securities constitutes the principal in this scenario, banks and rating agencies together

constitute the agent. In the financial markets, ratings agencies behave as used car salesmen in the

classical Akerlof model for the Market for Lemons, passing-off toxic assets as if they were AAA assets.

When the buyers’ market realizes the true value of the assets in question, it reacts accordingly.

The credit rating agency (CRA) is paid to rate bonds. It is paid a commission by the party issuing the

bonds. (We presume that commission income could be maximized by overstating the value of the bonds

5Official Journal of the European Union, 2009

6Akerlof, G.A., 1970.





(e.g. by understating the default risk), a service which can be bought by the issuing party. Alternately,

the issuing party can hire the agency as a consultant and ask how exactly to make the asset’s risk appear

minimal according to the model used by the CRA.) The market is the principal. The agent is the

combination of the issuing party and the CRA, as the issuing party collects the income, and the credit

rating agency overstates the asset’s value by understating its risk. In terms of risk-adjusted return,

genuinely risk-free assets, whose return reflects genuinely low-risk nature, simply cannot compete with

the prospect of low risk and high returns. Accordingly, ABS assets and mortgage derivatives came to

dominate other low-risk assets in the financial markets.

When market players realize the true risk-return profile of the assets, they should reduce their valuation

of the assets, triggering a sell-off. In the case of institutional investors, many of them would be obliged

by fiduciary standards to sell once the assets demonstrated their non-AAA nature. Ultimately, the

market for them should evaporate (which took place in 2008).

Efficient market condition:

= (ℎ , )

In an efficient market, prices reflect all available relevant information. Namely, these are discounting,

cash flows and risk.7

Formally, a simple-bond valuation model, while not representative of the actual

complexity of the Asset-Backed Securities (ABS) and Collateralized Debt Obligations (CDO) markets

which crashed, sparking the 2008 financial crisis, can nevertheless be used to convey the fundamental

argument.

= ( ℎ ) ∗

To make the model more specific:

= [ℎ

(1 + )

=1

] ∗ 1−

Here, cash flows (e.g. coupons and face value) are discounted with interest rate r. Dfr denotes the

bond’s risk of default.

7Fama, E.F., 1970.





With this in mind, we must now ask what the market would look like with information asymmetry, in

which in question of whether the bond prices are justified by the underlying cash flow and risk profile

cannot be quickly and transparently verified. Fundamentally, rather than being able to purchase, for a

given price P, a bond of a specific quality in terms of risk and cash flow, the buyer would only be able to

purchase a bond whose quality is at most as good as what is being promised.8 Thus,

≥ [ℎ

(1 + )

=1

] ∗ 1−

At this point, Akerlof-style information asymmetry models discus the distribution of quality of the assets

on the market. Let us suppose that on average, quality of assets is inferior to what is promised. The

primary manifestation of quality in this model is the risk profile of the asset in question. Because the risk

profile of a security is usually the most difficult aspect of a financial security to verify independently, it is

the easiest aspect to misrepresent. Suppose that a particularly difficult to detect additional risk would

enter the securities market. Such that average quality is diminished:

≥ [ℎ

(1 + )

=1

] ∗ 1− (+ )

This B-class asset includes an additional risk factor (k), which is not detectible by the purchaser of the

securities at time of purchase, and which causes default risk to increase significantly. Under complete

and transparent information, its value would be considered far inferior to high-quality, AAA debt. Due to

information asymmetry in the market however, the additional risk is not being duly compensated by the

price paid for the asset. Furthermore, because of the proliferation of undetectable B-class assets in the

financial market, the average financial security which sells for a given price is in fact of a value lower

than the price paid, due to the risk profile of the asset in question. Here, the distribution of

undetectable B-class debt vis-à-vis A-class debt leads to a reduced average quality of debt, such that its

value is lower than the asking price of the debt instruments in question.

≥ [ℎ

(1 + )

=1

] ∗ [1− + ()]

And

0 ≤ = [ − )− ( − ] ≤ 1

Stated plainly, this fundamental misalignment between risk-weighted returns and prices, caused by

conflicts of interest at ratings agencies is a market failure. This failure caused massive losses of investor

confidence and widespread financial market instability. In a marketplace of rational actors such as

banks, hedge funds, and pension funds, buyers would shy away from the purchase of any security for

which the price is not justified by the cash flow and risk profile of the asset. According to the Akerlof

8Macho-Stadler, I., Pérez-Castrillo, J. D., 2001





model’s prediction, once knowledge of k and of the distribution thereof becomes public, everyone

would sell, and the market for the asset would collapse.9

In this way, the effects of information asymmetry on the financial markets can be seen to cause first the

mis-valuation of asset-backed securities, followed by the evaporation of the market for asset-backed

securities. This is not the sort of incentive which promotes transparent, stable growth in financial

markets.

Why Asset-Backed Securities?

The 2008 financial crisis begs the following question: If the conflicts of interest and the information

asymmetry led to the market-failure of asset-backed securities, why did it not also lead to the market

failure of other types of securities, or to the total failure of the bond market overall, given that the

rating agencies are active in many markets simultaneously? After all, the potential for information

asymmetry to affect the financial markets exists in many places.

The answer, as one would expect with any information asymmetry scenario, involves novelty,

intransprency, and complexity in the market. Because of the complex and heterogeneous bundle-and-

slice techniques used in the construction of ABS and CDO, valuation thereof was considered among the

most obscure in the financial industry, meaning that only a select few economists at the largest

investment banks were actually able to value them accurately. In addition, elements of the valuation

function for ABSs classified as mortgage-backed securities (MBS) were known to be unreliable (by theinformed parties).10 Compounding the problem was the emergence of second-order derivatives such as

CDO-squared derivatives, which were created by bundling-and-slicing the already bundled-and-sliced

CDOs and ABSs.11 Furthermore, the same bundle-and-slice techniques made it difficult to determine

specific risk characteristics such as correlation between various assets.

Because the market for asset-backed securities was new, intransparent, and complex, it was clear to

those parties creating and valuing ABS and CDO that the market at large did not fully understand how to

evaluate the risk profiles of this new type of asset. It is here that the mis-valuation of the financial assets

was most plausible and where information asymmetry could most easily play a role.


10Hull, J. C., 2009

11Vander Vennet, R., 2010





The same is not true of simple bonds. In fact, in more simple areas of the financial markets, the risk

profile and valuation of financial assets can be estimated in-house. Furthermore, possibilities exist for

third-party estimations of valuation and risk.12

What to do Next?

Fundamentally, the problem has two elements which need resolution. First, information asymmetry and

incentive disparity inherent in the financial markets needs to be addressed. Theoretical models for

resolving information asymmetry prescribe proper incentive alignment between buyers and sellers, such

that sellers have the incentive to signal accurate and timely information to buyers.13

In the financial

markets, this signaling function is in fact, the fundamental role of the credit rating agency.

This brings up the second element of the problem. Namely, that the rating agencies ’ incentive to signal

accurate and timely information to the buyers’ market, is undermined by a conflict of interest.14 The

incentive of the rating agencies is thereby aligned to the issuer due to the agencies’ remuneration

structure. The classical and conventional solution would be to create incentive compatibility between

the signaling agent and the buyers’ market.15

In order to foster incentive compatibility, the classical academic model for this type of information

asymmetry, (which was originally designed for the used car market) would prescribe for the quality of

assets to be signaled via a warranty.16

In the automobile markets, this would mean that the buyer would

be protected by the seller for at least part of the risk of the car’s failure. In financial market practice,debt-related assets do not break down but rather, they enter default. This approach would thus mean

shifting part of the default risk to the agent. Unfortunately, such an arrangement would not be useful in

cases in which the issuing party enters bankruptcy, as would likely be the situation during episodes of

default on the financial markets.

An alternative form of incentive compatibility currently debated in academic circles involves the

introduction of malpractice fines for the rating agencies. This approach however, is non-viable chiefly for

two reasons. First, in a de jure sense, it is difficult to regulate rating agencies because they are not based

in Europe (outlined as an important factor in the April 2009 proposal for regulation of the European

12Berk, J. and DeMarzo, P., 2007


14Official Journal of the European Union, 2009


16Akerlof, G.A., 1970





Parliament and of the Council on Credit Rating Agencies).17

Moreover, legally speaking, opinions on the

quality of debt instruments can be considered to be protected as free speech. Second, in a de facto

sense, the imposition of penal regulation to the banking system would immediately generate staunch

opposition from both the banking lobby and many political parties, undermining the viability of any

legislative efforts on this issue.

While the need for independent, objective, and high-quality asset rating is recognized by the European

Parliament as a fundamental need for well-functioning markets, there seems to be no real consensus for

how to ensure such rating standards.18 Furthermore, the EU’s Regulation No 1060/2009, while having

several positive features, falls short of proper incentive alignment for three key reasons:

The regulation does not create a general obligation for financial instruments to be rated under

it.

Although the regulation addresses third-country credit rating agencies, jurisdiction over the

matter is not definite.

The regulation does not address the remuneration structure of credit-rating agencies.

Fortunately, the incentive-alignment problem may be easier to address than it would seem at first

glance. In fact, it can be addressed with minimal interference in the financial markets via a parallel rating

of securities.

The Public Financial Rating Agency

As we have seen, the conflict of interest in the remuneration scheme of the private and for-profit ratings

agencies has led to market failure in the market for rated financial assets.

A non-market actor who issues ratings in parallel to the private ratings agencies would fundamentally

transform the landscape of the market for ratings and rated securities. This is because if one of the

rating agencies would give a consistently non-conflicted rating to securities, the competing agencies

would find it difficult to justify a substantial deviation in ratings. Such an agency would have a deeply

positive effect on the incentive landscape in the marketplace. It would promote the right sort of

incentive compatibility in the ratings market by making any misevaluation of financial assets or their

underlying risk more evident, undermining the reputation of the rating agencies if and when conflicts of

interest bring them to misrepresent the value of the financial assets they are charged with rating.

17European Parliament, Committee on Economic and Monetary Affairs, 2009

18Ibid





Examining the proposal as a coordination game, we can see that the private CRA is incentivized not to

misrepresent a financial asset’s value or risk. Indeed, a large unexplained deviation (positive or negative)

would lead to a diminishing of credibility for the private CRA vis-à-vis the pubic CRA. This would be the

case due to incentive differences for the two agencies. The fact that the conflict of interest in the privateagencies is widely known would lend credibility to the views of the public rating agency over that of a

private rating agency in the event of a significant divergence of rating.

Minor divergences would nevertheless be unlikely to attract significant attention. Indeed, it is currently

the case that rating agencies differ on the credit ratings they assign. Aware of the situation, private

rating agencies would exercise great care in rating financial assets in such a market environment.

Furthermore, private rating agencies can be expected explain the reason for any ratings divergences in

considerably greater detail than they would in the present situation. Overall, this change in incentives

and behavior on the part of private rating agencies would cause more accurate information to be

disclosed in the financial markets.

We next come to the question of what such a parallel rating agency should look like. Essentially, such an

agency should have two characteristics. First, it would need policy independence of a shape similar to

that of central banks, so that even politically strategic securities could be rated impartially. This would

foster the public rating agency’s credibility. Second, in order for the agency’s ratings to carry some

weight, pension funds based in Europe could be required to –at least take into account – the views of the

public rating agency on rated assets whilst deciding on their asset positions. While pension funds should

not be forced to base their outlooks and asset positions solely on the views of the public rating agency,

they should comment on their asset positions vis-à-vis the views of the public rating agency, as part of

their fiduciary-standard responsibilities. This should especially be the case during episodes of

public/private ratings divergences. Furthermore, any relationship between the public rating agency and

security issuing parties would be expressly banned and strictly watched.





There also exists the issue of government treasury securities and other public-sector debt instruments.

Although in a formal sense, both independence and clear partition would exist between the agency and

the public-sector-debt-issuing party, the possibility of partiality concerning government treasury

securities may still exist and cannot be ignored. In an EU context, this would include EU-issued, ECB-

issued, and member-nation issued securities. In essence, there are two manners in which this issue may

be addressed. The public rating agency could either be barred from rating public-sector debt or else be

required to explicitly comment on the possible strategic partiality of its opinion in the situation.

Quis Custodiet Ipsos Custodes? Questions of Integrity:

Concerning questions of the integrity of the rating agency itself, the agency should be subject to an

environment of checks and balances similar to that of a central bank. The experience with central bank

independence and accountability has thus far generally shown good results vis-à-vis the maintenance of

integrity and neutrality.

To be specific about the nature of independence rules which could be applied, one may refer to the

ESCB’s independence rules. First, there is the issue of personal independence. While it is in fact the case

that European political authorities nominate the central bank governors, terms of office are fixed,

except in cases of serious misconduct or inability to complete the term, protecting the governors against

arbitrary termination, as established by article 14.2 of the Statute of the ESCB19

. Furthermore, “serious

misconduct” should be determined by judicial rather than political authorities. Next, is issue of

functional independence. A truly independent agency should be free to design its policy such that it

achieves its policy objectives.

20

In the context of an independent public CRA, this would mean that notonly should the agency not be pressured with respect to what ratings to assign, but it should also not be

pressured regarding the methodology for how it would arrive at its ratings.

Fundamentally, the agency’s integrity would be maintained by virtue of its policy independence. The

main idea is that conflicting influences on the public agency’s judgment would most likely emerge

regarding the issue of public-sector and politically strategic debt-issuances. Independence from the

political authorities who originally nominated the agency’s directors would insulate the agency from

such conflicts. It is the opinion of the ECB nevertheless, that policy independence is not a counterweight

to accountability. Independence and accountability are mutually reinforcing as long as clear andmeasurable policy objectives are [exogenously] outlined.21 In any case, policy independence can also be

made subject to a balance of powers, in a manner similar to the separate braches of a nation’s

government. Furthermore, is it also the opinion of the ECB that democratic control over the

19Bini Smaghi, L., 2007

20Ibid

21Ibid





independent institutions needs to be maintained in order to prevent “excessive discretion and unclear

objectives, which risks creating political backlashes against independence.”22

Indeed, it is a fact that

while Germany’s monetary policy (i.e., its participation in Eurozone) is independent of the nominating

political authorities, it is overseen by the country’s judicial branch. Thus, the concept of independence

for a public financial rating agency would mean that while political authorities should be able to define

the agency’s mission and judicial authorities may evaluate whether or not this mission is being

effectively addressed, no one would tell the agency how to address its stated mission.

Conclusion

The information asymmetry aspect of the 2008-2009 financial crisis has taken the form of adverse

selection in the market for asset-backed securities, collateralized debt obligations, and derivatives

thereof. As in the classical adverse selection model, buyers were misled about the quality of the assets

on the market. In an environment in which buyers could not independently determine the quality of the

assets, private rating agencies colluded with asset-issuers to signal inaccurately-high asset quality.

Presumably the reason rating agencies had for doing so was the combination of conflict of interest due

to their remuneration structure and an opaque, non-transparent market for ABS and CDO.

While the classical response to this situation would be to align incentives via warranties, this is not

viable on the financial markets because such clauses could not be activated during bankruptcy.

Therefore, an effective solution to the problem would be the establishment of a policy-independent

public-sector rating agency to issue asset-quality signals in parallel to the private-sector rating agencies.

In this way, private CRAs would be incentivized to consistently issue accurate signals. The public CRA’sintegrity would be kept intact via the combination of operational, personal, and policy independence

with a system of judicial checks and balances modeled on central bank architecture.

22Ibid





References:

Akerlof, G. A., “The Market for "Lemons": Quality Uncertainty and the Market Mechanism” The

Quarterly Journal of Economics, (Aug., 1970), Vol. 84, No. 3. pp. 488-500.

Berk, J., DeMarzo,P. “Corporate Finance” Pearson Education, Inc. 2007.

Bini Smaghi, L., “Central Bank Independence: From Theory to Practice”, Speech at Conference for Good

Governance and Effective Partnership, Budapest, Hungarian National Assembly, 2007.

European Parliament, Committee on Economic and Monetary Affairs, “I Report on the Proposal for a

Regulation of the European Parliament and of the Council on Credit Rating Agencies” (COM(2008)0704 –C6 0397/2008 –2008/0217(COD)) Rapporteur: Jean Paul Gauzès, 2009.

Fama, E.F., “Efficient Capital Markets: A Review of Theory and Empirical Work”, The Journal of Finance,

25(2), 1970, pp. 383-417.

Hull, J. C. “Options, Futures, and Other Derivatives” Pearson Education, Inc., 2009

International Monetary Fund “Global Financial Stability Report: Financial Market Turbulence Causes,

Consequences, and Policies” World Economic and Financial Surveys, Washington DC, October, 2007

International Monetary Fund “Global Financial Stability Report: Containing Systemic Risks and Restoring

Financial Soundness” World Economic and Financial Surveys, Washington DC, April, 2008

International Organization of Securities Commissions “Code of Conduct Fundamentals for Credit Rating

Agencies”, December, 2004

Macho-Stadler, I., Pérez-Castrillo, J. D., “An Introduction to the Economics of Information: Incentives and

Contracts” Oxford University Press, 2001.





Official Journal of the European Union “EC Regulation No 1060/2009 of the European Parliament and of

the Council of 16 September 2009 on Credit Rating Agencies”, Brussels, September, 2009

Skidelsky, R. “Keynes, Return of the Master” Penguin Books Ltd., London, 2010

Vander Vennet, R. “Financial Crisis: 2007-2010” Speech at Ghent University, September, 2010.

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