Tuesday, August 23, 2011

CONTEST LOSERS: design an effective ratings agency

PROBLEM:  lousy ratings

1.  WHO:  Ratings companies like Moody's offer favorable ratings
2.  INFO:  Ratings agencies have access to information that would predict poor performance, although not for Black Swan type events, which are inherently unpredictable.
3.  INCENTIVES:  Ratings agencies have an incentive to offer favorable ratings regardless of risk; otherwise they won't get chosen by the issuers.

1.  DECISION RIGHTS:  Let someone else do the ratings, like a regulator.  The failure of regulatory agencies in preventing obvious frauds, like Madoff's Ponzi scheme, suggests that this may not be such a good solution.
2.  INFO:  How do rating agencies get access to info?  Here several "private sector" solutions suggest that disclosure of information would be in the issuer's self interest, i.e., those that did not disclose or restricted access would receive less favorable ratings.  But if this is the case, why did the problem arise in the first place?
3.  INCENTIVES:  Sever the tie between the choice of a ratings agency and the payment from the issuer.  Two types of solutions fall into this category:  (i) let consumers pay (those that buy the securities that get rated); and (ii) let the ratings agency be chosen by lottery from a qualified pool (Moody's, S&P, others).  The problem with (i) is free riding, ratings are information that is easily shared, so why should I pay for it?  The problem with (ii) is shirking, i.e., what incentives to ratings agencies have to do a good job if they are chosen regardless of their performance.  Several solutions suggested customers ratings of the ratings agencies to give them an incentive to work hard.

Interestingly, no one chose litigation as a possible solution:  give the agencies a "fiduciary responsibility" to the investors that rely on them.  This would open them up to lawsuits if they acted irresponsibly.  That no one chose it underscores the difficulty that a regulator, or a litigator, would have in gathering information and determining whether the agencies were doing a good job.

BOTTOM LINE:  everyone loses.  Come by my office and pick up a consolation mug and if you want me to sign your book, bring it by.

MY SOLUTION?: get rid of the implicit guarantees that investors will be bailed out if their investments go south.  This would give them an incentive to scrutinize investments a lot more closely than they had been doing because if they don't, the market will punish them more swiftly and surely than any regulator.

Let me defend myself against the expected ridicule by posing a simple question:
QUESTION:  How many economists does it take to screw in a lightbulb?
ANSWER:  None, the market will do it.  


  1. As I reviewed the syllabus for Professor Froeb's class in hopes of finding a way to improve my grade, I came across class participation: 1) prepare for class - check, 2) attend and be attentive - check, 3) comment on the blog - uh oh! How did I overlook this? I am the decision maker and obviously have the incentive since it is MY grade. But what I was missing was the information. Now I have the decision authority, the full information and incentive to post. Thanks Froeb!

  2. In my view one should always rate things themselves, it is the way we will find positive results. I am trading with OctaFX broker and through their service, I am always happy with doing anything and why not, I get 50% cash back on all trading orders including the losing trades too, so it is something that really makes anyone feel happy and relaxed with work because this is how we will be able to get regular profits without struggling at all.