1. The Economics of Solicited and Unsolicited Credit Ratings Paolo Fulghieri Gunter Strobl Han Xia discussion by Adlai Fisher Sauder School of Business University of British Columbia UBC Winter Finance Conference March 5, 2011

2. Outline 1)Some institutional detail on credit rating agencies 2)The model and comments

3. I. Credit Rating Agencies

4. History of Ratings Agencies John Moody published first publicly available bond ratings in 1909 (mostly railroad bonds). –Poor’s Publishing, 1916 –Standard Statistics Company, 1922 –Fitch Publishing, 1924. Manuals sold to investors (“investor pays model”) –Initial role purely market driven

5. History of Ratings Agencies Major change in role of U.S. ratings agencies in 1936 –Bank regulation prohibits investments in “speculative investment securities” as determined by “recognized ratings manuals” (Moody’s, Poor’s, Standard, Fitch) –Insurance regulators of all 50 states follow suit over years –1970’s federal pension regulators adopt similar requirement –  Creditworthiness judgments of CRA’s achieve force of law SEC formalizes role of CRA’s in 1973 –Defines category of “nationally recognized statistical rating organization” (NRSRO), grandfathers Moody’s, S&P, Fitch –Only ratings of NRSRO’s deemed valid for determining broker-dealer capital requirements –Other regulators soon adopt SEC conventions

6. Industry Structure Over 1975-2000, SEC designates four additional firms as NRSRO’s, but mergers restore to original three –SEC criticized for opaqueness in criteria to achieve NRSRO designation, creates additional barrier to entry –Credit Rating Agency Reform Act (2006), requires SEC to set up transparent criteria for NRSRO’s –Seven new NRSRO’s designated in 2007 Current industry structure remains highly concentrated –Moody’s plus S&P have over 80% market share in U.S., adding Fitch concentration exceeds 95% Worldwide over 100 CRA’s, but high concentration within geographical segments, S&P and Moody’s have global reach and affiliations

7. Importance of CRA’s New York Times (1996), on sovereigns: –“There are two superpowers in the world today... the United States and Moody’s Bond Rating Service. The United States can destroy you by dropping bombs, and Moody’s can destroy you by downgrading your bonds.” Clear evidence that stock and bond prices react to ratings changes –Disagreement about how much of this is due to information versus the importance of CRA’s in regulatory oversight

8. Role of CRA’s Characterize themselves as part of “financial media” –Issue opinions, but these opinions are protected by First Amendment rights to free speech –Difficult to establish legal liability for opinions Have access to inside information for solicited ratings –Exempted from Reg FD requirements

9. Evolution in Business Model Late 1960’s/early 1970’s: business model largely changes from “investor pays” to “issuer pays” –Difficulty of protecting subscription content –“Ratings agencies have evolved from information providers to purveyors of `regulatory licenses.’” (Council of Institutional Investors) Moody’s, only free-standing major CRA, has about 70% of revenue from ratings, remainder from related services

10. Current Issues Ratings shopping –Especially relevant for structured products, where issuers repeat business very frequently Conflict of interest under “issuer pays” –S&P: “clear separation between those who negotiate the business terms and the analysts who conduct the credit analysis” –Counterexamples in literature (Hanover re)

11. Unsolicited Ratings Tend to be lower than solicited –Disagreement whether this remains controlling for issuer characteristics –Can be used as a punishment for not soliciting a rating Ratings agencies argue they are necessary to provide a complete portfolio of ratings for investors –Also appear to be used prominently when entering a new market (e.g., Japan) Unsolicited ratings use only public information; recently are distinguished as “unsolicited” by CRA Empirical evidence: between 5 and 20% of ratings depending on market

12. II. Model and Comments

13. Model Firm types θ={G,B,N} drawn iid for t=1,2 –G (p=βα): investment project succeeds with prob q –B (p=β[1-α]): investment project fails, payoff zero –N (p=1-β): no project, payoff V*≥0 –Objective: “Maximize current market value of shares” CRA: honest (p=μ) or opportunistic (p=1-μ) –Propose solicited rating rs={h,l,0} and fee to issuer –Issuer accepts or declines –If solicited declined, give unsolicited rating ru = {h,l,0} –Type N firm may only receive rating r=0 Investors: Bayesian update on firm and CRA types after observing ratings and payoffs each period

14. Solicited-only Equilibrium Firms invest if and only if H-rating received Period 2: opportunistic CRA offers H-rating to all issuer types; fee depends on CRA reputation Period 1: opportunistic CRA charges fee V(H)-I-V(0) for H-rating, fee independent of issuer type –G firm offered H-rating with probability 1 –B firm offered H-rating with probability k(H)>0 Ratings inflation k(H) increases in payoff R of successful investments and is inverse U-shaped in prior CRA reputation

15. Equilibrium with Unsolicited Ratings Period 2: opportunistic CRA offers H-rating to all issuer types; fee depends on CRA reputation Period 1: opportunistic CRA charges fee V’(H)-I for an H-rating, fee independent of issuer type –G firm offered H-rating with probability 1 –B firm offered H-rating with probability k’(H)>0 –If no solicited rating, CRA issues unsolicited UL-rating Results –Fees higher when unsolicited ratings permitted (CRA can separate L-type from 0-type with UL-rating, and L-type has weakly lower value by assumption) –For low values of V*, ratings are more accurate and social welfare is higher; for high values of V* the opposite can hold

16. Comments Issuer objective function depends on current price only, deserves more discussion; –L-type willing to pay to withhold information when pooled with 0-type, even though this has no impact on ultimate cash flow of L-type The objective function of the ethical type is not fully specified –does not allow determination of fees paid to ethical type –what happens if issuer refuses fee proposed by ethical type? Assume that fees may depend on rating –CRA’s claim this is not accurate; deserves more discussion

17. Comments Assume CRA infrormation quality independent of whether rating is solicited or unsolicited –Seems at odds with inside information available to CRAs in solicited ratings and exemptions from reg FD; deserves more discussion How realistic is assumption that 0-type cannot be rated? –Firms are collections of projects and a very large proportion of major firms have some basis on which they could be rated –Using this device seems to unnecessarily limit scope of model; if a similar result could be obtained with a less restrictive assumption, would be preferable Duopoly?

18. Conclusion The paper tackles an important and interesting institutional feature of information intermediation in financial markets After years of observation, which firm, Moody’s or S&P, is the ethical one? –Tongue-in-cheek, but perhaps give more guidance about how to relate the model to current financial markets