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NRSRO Incentives

Some narratives of the recent financial crisis include criticizing the Ratings Agencies for being very generous in their awarding of AA and AAA ratings to (what turned out to be) risky mortgage securities. One reason for this, it is asserted, is that the agencies were paid by the bond issuers rather than the bond investors. I have two major problems with this narrative that are not commonly discussed in papers that promote this view (or those that attempt to exonerate them).

Problem #1: It is not clear to me that the issuer of a bond needs to have its issue rated AAA in order to sell it. There are markets, very robust markets, for higher risk securities. Yes, interest rates would be higher. And yes there are regulatory incentives to have bonds rated AA and AAA (for example, Basel capital requirements allow pension funds to purchase only investment grade securities). But a priori, issuers can sell bonds that are not rated AAA. Remember the junk-bond markets in the 1980s? Of course, if you could sell “junk” and manage to have it rated AAA, that is fantastic for the issuer in the short-run, but competition ought to weed out these folks pretty quickly if it turns out they were doing this regularly.

Problem #2 (and the reason for the post): Municipalities are among the largest issuers of debt that is rated by the NRSROs. In other words, if you think there is a moral problem with “issuer pays” it is not unique to the private sector. Indeed, given the massive budget crisis many of our municipalities face, it is a wonder that so many of their securities are rated as highly as they are. Where are the outraged papers talking about conflicts of interest here? Yes, cities can raise taxes, which makes their debt “safer” than corporations, but that does not change the underlying dynamics.

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