August 15, 2007
Rating Inflation.
Posted by William Birdthistle

With the Dow's introductory curtsey below the 13,000 mark this morning, the wild swings in the market of late seem to merit comment.  The Wall Street Journal obliges with its lead today, a piece -- under the witty (dare I say, Murdochian?) caption, "Credit and Blame" -- pointing the finger at S&P, Moody's, and Fitch.  The agencies "gave top ratings to many securities built on the questionable [subprime] loans, making the securities seem as safe as a Treasury bond."

As we did on last night's Marketplace, I suspect we'll hear a good deal more in the coming weeks and months about the incentives and compensation structure of the ratings industry:

The subprime market has been lucrative for the credit-rating firms.  Compared with their traditional business of rating corporate bonds, the firms get fees about twice as high when they rate a security backed by a pool of home loans.  [W$J]

And who pays that fee?  The banks and mortgage companies who create the products.  And when an agency won't render a positive rating?  Customers can "take their business to another rating agency."  [W$J]

This symbiosis of rater and rated is reminiscent of the mutual fund problems that flared up in 2003.  Lipper and Morningstar purport to rate, recommend, and supply "leading fund intelligence" on mutual funds, but critics like David Swensen note that their system is retrospective and largely useless as an aide in forecasting: e.g., tech funds received middling grades in the mid-nineties (just before their historic run up) and spectacular grades at the millennium (just before their historic crash).

Of course, even law schools ask the graded to pay the graders -- with what some see as a concomitant increase in the rosiness of the ratings (i.e., grade inflation) -- so perhaps this problem is impossible to avoid.  Or can we ask employers to pay universities to grade potential hires?

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