Ratings Shopping and Asset Complexity: A Theory of Ratings Inflation
34 Pages Posted: 6 Nov 2008
Date Written: October 24, 2008
Many blame the recent financial market turmoil on ratings agencies. We develop an equilibrium model of the market for ratings and use it to examine popular arguments about the origins of and cures for ratings inflation. In the model, asset issuers can shop for ratings - observe multiple ratings and disclose only the most favorable - before auctioning their assets. When assets are simple, agencies' ratings are similar and the incentive to ratings shop is low. When assets are sufficiently complex, ratings differ enough that an incentive to shop emerges. Thus an increase in the complexity of recently-issued securities could create a systematic bias in disclosed ratings despite the fact that each ratings agency discloses an unbiased estimate of the asset's true quality. Increasing competition among agencies would only worsen this problem. Switching to a investor-initiated ratings system alleviates the bias, but could collapse the market for information.
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