FOO Law and Economics

Monday, January 12, 2009

What do we know about sovereign credit ratings?

Not much, apparently. But this much was concluded by IMF staff in a 2002 working paper (click here). Most of the conclusions also apply to non-sovereign borrowers, and would be relevant to today's financial crisis.

1. There is a clear upward or "favorable" bias in favor of the debt issuer. This is evidenced by subsequent "failure" in that the ratings exhibit instability when a debt or financial crisis affects the debtor. (I might argue that this bias is not necessarily bad for the borrower: it gets to benefit from a lower interest rate than otherwise.)

2. The ratings of the major agencies (Moody's and Standard and Poor's) exhibit "herd" behavior: when one rates up or down, the other tends to follow.

3. The behavior of ratings agencies can be explained in part, and not very precisely, from the fact that they earn fees paid by borrowers. There is an element of "pleasing the client." But the other fee-generating activities of ratings agencies raise possible "conflicts of interest" (vis-a-vis the investor community that relies on the ratings).

4. Important causes of ratings failure stem from "information risk" and "analytical constraints." The first arises from the risk that the debtor may not wish to "tell the whole story" in order to bias the rating upward. The second comes from the fact that predicting financial problems or crises is very inexact, even as traders use ratings to measure default risk.

5. The U.S. official view is to encourage the activities of ratings agencies because credit ratings, when available, facilitate borrowing in the capital markets by debtor countries, particularly those with low incomes.

The following are comments on my part:

An interesting conjecture is this: What accounts for the existence of ratings and rating agencies is the need of portfolio managers to have someone "to blame" if things go wrong. Without the credit ratings, they could be liable in a tort suit by irate investor clients. The problem is that in a "bubble" phase when debt issues are "hot," credit ratings can underpin investor irrationality that would eventually lead to a financial crisis.

A related policy question is: Should credit ratings agencies be regulated? A first impression answer is yes, because their product is a public good (if it disseminates information efficiently) or public bad (if it distorts information). The really tough question is who should do the regulating, and how.

This post will be revised with further research. Please click on the title of this post to make or see comments.

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