The Credit Raters Oligopoly

Sometimes, the obvious solution to Agency Problems turns out to be impossible. Disorganized Crimes discussed to an obvious agency issue in the meltdown of the 2007-8 Credit Crisis. Who paid for credit ratings seemed to be an obvious conflict of interest problem for issuers of complex mortgage securities. Credit rating agencies competed for business of credit issuers, and the rating issuers didn’t want to lose issuer business by looking more deeply into the real credit quality of complex mortgage structures, and, more particularly, what could happen if the housing market went into sharp decline. Institutional buyers of mortgage securities needed particular ratings of these structured issues that would qualify them as consistent to their respective investment mandates. They were label and yield driven.
Everything was fine…until the wheels came off the mortgage bus!

Obviously, conflicts of interest made quality credit reporting highly suspect, deeply troubled by agency considerations. Solution: Have buyers pay for ratings!

Maybe? Maybe Not!

Along comes a new credit ratings agency with that kind of business model. The new Credit Rating agency business model seemed to be an obvious way to break up the credit ratings oligopoly? That’s what Jules Kroll thought, and his successful prior career in providing security to large firms seemed to make him a highly qualified entrant to the Credit Rating market.

Guess what? Credit portfolio managers like free lunches. Pay for ratings that known credit raters provide freely to the credit issuers? Didn’t happen! Kroll found it difficult to attract customers.

After struggling for a few years, poor market responses convinced him that to get customers he had to play on the traditional rating agency ball field. Let the issuers pay. Back to square one.
What’s the real lesson from this market test? Markets don’t price extreme events very well! Credit crises don’t happen frequently and 2007-8 had some singular peculiarities. They are not an everyday event ,and in addition, there was a new regulatory regime in place after Dodd-Frank and the Fed got involved with financial intermediary balance sheets. Users of credit ratings didn’t place a high enough value on receiving credit ratings likely to be less influenced by the obvious Agency issue of having the issuer pay the Rater for its services. The obvious conflict of interest got very little attention, and few customers of credit ratings were willing to pay for them. Mr. Market spoke loudly!

A similar situation might be the relative lack of shareholder interest in comparative compensation data that Public Firms must now release when Executive Compensation plans are being established. That raises interesting issues on assessing the costs and benefits of regulations designed by regulators with the “public interest” in mind.
At the end of the day, the failure of a buyer-paid credit rating agency tells about how markets tend to diminish “highly less probable events.”

Sometimes the “obvious” isn’t really so obvious!