Gone Shopping: A Theory of Ratings Inflation

Laura Veldkamp and Vasiliki Skreta

No 916, 2008 Meeting Papers from Society for Economic Dynamics

Abstract: Many blame the recent financial market turmoil on malfeasance of ratings agencies, who had incentives to bias their ratings. But these incentives had existed for decades. Why did the ratings bias issue only recently emerge? We model asset issuers who can shop for ratings -- observe multiple ratings and disclose only a subset -- before auctioning their assets. When assets are simple, agencies' ratings are similar and the incentive to 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. This is true even if each ratings agency discloses an unbiased estimate of the asset's true quality. Increasing competition among agencies would not solve this problem. Switching to a buyer-initiated ratings system alleviates the bias, but could collapse the market for information.

Date: 2008
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