Looking at Credit Rating Agencies Through a Leegin Lens

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Mark Patterson, Jan 28, 2014

In a 2007 memorandum, Raymond McDaniel, the Chairman and CEO of Moody’s Corp., described competition among credit-rating agencies in a way that should give antitrust lawyers pause:

“Ideally, competition would be primarily on the basis of ratings quality, with a second component of price and a third component of service. . . . The real problem is not that the market . . . underweights ratings quality but rather that, in some sectors, it actually penalizes quality by awarding rating mandates based on the lowest credit enhancement needed for the highest rating. Unchecked, competition on this basis can place the entire financial system at risk. It turns out that ratings quality has surprisingly few friends: issuers want high ratings; investors don’t want rating downgrades; short-sighted bankers labor short-sightedly to game the rating agencies for a few extra basis points on execution.”

The basic claim here—that there are fundamental problems with competition in the credit-rating business if we care about ratings accuracy—is supported by financial research. Bo Becker and Todd Milbourn have provided evidence that the entry of Fitch as a third credit-rating agency in the market actually led to less accurate ratings. More specifically, increases in Fitch’s market share were associated with decreases in rating quality, including both higher ratings and less correlation between ratings and actual bond yields.

Of course, this is a failure of competition only if we view the goal of competition as producing accurate ratings. If the goal of competition among credit-rating agencies is to make them serve the needs of their customers, competition appears to be working. The customers who pay for ratings are the issuers of securities and, as McDaniel describes above, those issuers want higher ratings, not more accurate ratings.