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1 | Rating a Lemon in the Market
January 31, 2011 Maxens Berre Knowledge House Maastricht
The Case for a Parallel Rating Agency: Rating a Lemon in the Financial Market
Abstract
This paper offers an explanation for the 2008-2009 financial crisis using an adverse selection model for
the asset-backed security and collateralized debt obligation markets, in which more than 90% of assets
enjoyed a AAA rating despite being based on sub-prime real-estate lending. Because the classical
adverse selection incentive-alignment response would be ineffective during episodes of bankruptcy in
the financial markets, alternate arrangements for incentive-alignment are necessary. A public-sector
rating agency would align the incentives of private-sector credit-rating agencies via a reputation effect.
This public agency would in-turn maintain its integrity and neutrality via central-bank-style policy
independence architecture.
Keywords: Adverse Selection, Credit Rating Agency, Financial Markets, Policy Independence, Conflict of
Interest, Financial Crisis
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2 | Rating a Lemon in the Market
January 31, 2011 Maxens Berre Knowledge House Maastricht
Introduction
In the US the 2008-2009 financial crisis began as the bursting of a bubble in the real-estate market.
Securities based on sub-prime mortgages, which had found their way onto the balance sheets of
investment banks all over the world started to drop in value as the underlying mortgages dropped in
value. These mortgages decreased in value because both the likelihood that they would be paid off declined with the housing market and because the real-estate which these mortgages were based on
also dropped in value. Overnight, investors across the world dumped their mortgage-derived and
collateralized securities, causing their value to evaporate almost instantly.1
The general consensus is that this crisis began with the mis-pricing of risk.2
A primary contributing factor
to this mis-pricing was the widespread information asymmetry in the financial markets of the major
OECD economies. The initial tremors of the crisis can be traced back to the trade of collateralized debt
obligations (CDO) and asset-backed securities (ABS), which were trading as AAA-rated securities.
Essentially, toxic assets were traded globally under ratings which later proved to be wildly misleading.
This enabled origination of loans without regard to their soundness or sustainability, hoping only to sell
to a greater fool in a global game of hot potato. US lenders originated and world markets bought.
Underlying the entire housing bubble was senior AAA given to an unrealistically large share of
collateralized debt obligations (CDO) and asset-backed securities (ABS). Because most mezzanine
tranche, speculation-grade collateralized debt was recycled into AAA-rated CDO-squared, around 90% of
securities derived from sub-prime lending enjoyed AAA rating regardless of how risky the underlying
assets actually were.
3
This came despite the inherent instability of sub-prime real-estate debt.
4
1Skidelsky, R., 2010
2Ibid
3International Monetary Fund, 2008
4Ibid
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3 | Rating a Lemon in the Market
January 31, 2011 Maxens Berre Knowledge House Maastricht
One might ask how exactly it occurred that safe ratings were awarded to such a high proportion of
assets in this sector. This market failure, in a nutshell, can be summarized as one of conflicts of interest
and broken incentives.5 Specifically, rating agencies who are remunerated by the party issuing the
securities, who in turn has a clear and unmistakable interest in seeing the securities enter the market
with the most secure rating possible. Since rating agencies are private, for-profit companies, with the
obligation to maximize shareholder value there exists the very real risk of rating agencies assigning
unrealistically secure ratings in order to reach this end.
Adverse Selection: The Market for Lemons
In the view of economic theory, the situation can be best described as an Adverse Selection model,
more commonly known as a Market for Lemons. In the classical Akerlof Adverse Selection model, the
used car salesman is paid a commission by her dealership to sell used cars. Thus, her incentive is aligned
to that of the dealership for which she works. She can maximize her income by overstating the value of
the cars, making them more attractive to the market, thus increasing her commission. While the car
dealership and the salesman together constitute the agent, the buyers’ market is the principal who is
misled by the information asymmetry.
In Akerlof ’s model, the amount consumers are willing to pay for automobiles declines as they realize the
average true value of the used cars. This in turn, drives the average quality down further as good cars
are driven out of the market by the bad cars. This occurs presumably because the legitimate sellers
whose automobile prices accurately reflect quality simply cannot compete in terms of profitability and
cost with dishonest traders and are simply priced out of the market. Ultimately, the market for used carscollapses, and there is only demand for cars which are clearly absolutely at the bottom of the market in
terms of their intrinsic value.6
The story of Adverse Selection in the financial markets is similar. While the buyers’ market for rated
financial securities constitutes the principal in this scenario, banks and rating agencies together
constitute the agent. In the financial markets, ratings agencies behave as used car salesmen in the
classical Akerlof model for the Market for Lemons, passing-off toxic assets as if they were AAA assets.
When the buyers’ market realizes the true value of the assets in question, it reacts accordingly.
The credit rating agency (CRA) is paid to rate bonds. It is paid a commission by the party issuing the
bonds. (We presume that commission income could be maximized by overstating the value of the bonds
5Official Journal of the European Union, 2009
6Akerlof, G.A., 1970.
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(e.g. by understating the default risk), a service which can be bought by the issuing party. Alternately,
the issuing party can hire the agency as a consultant and ask how exactly to make the asset’s risk appear
minimal according to the model used by the CRA.) The market is the principal. The agent is the
combination of the issuing party and the CRA, as the issuing party collects the income, and the credit
rating agency overstates the asset’s value by understating its risk. In terms of risk-adjusted return,
genuinely risk-free assets, whose return reflects genuinely low-risk nature, simply cannot compete with
the prospect of low risk and high returns. Accordingly, ABS assets and mortgage derivatives came to
dominate other low-risk assets in the financial markets.
When market players realize the true risk-return profile of the assets, they should reduce their valuation
of the assets, triggering a sell-off. In the case of institutional investors, many of them would be obliged
by fiduciary standards to sell once the assets demonstrated their non-AAA nature. Ultimately, the
market for them should evaporate (which took place in 2008).
Efficient market condition:
= (ℎ , )
In an efficient market, prices reflect all available relevant information. Namely, these are discounting,
cash flows and risk.7
Formally, a simple-bond valuation model, while not representative of the actual
complexity of the Asset-Backed Securities (ABS) and Collateralized Debt Obligations (CDO) markets
which crashed, sparking the 2008 financial crisis, can nevertheless be used to convey the fundamental
argument.
= ( ℎ ) ∗
To make the model more specific:
= [ℎ
(1 + )
=1
] ∗ 1−
Here, cash flows (e.g. coupons and face value) are discounted with interest rate r. Dfr denotes the
bond’s risk of default.
7Fama, E.F., 1970.
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With this in mind, we must now ask what the market would look like with information asymmetry, in
which in question of whether the bond prices are justified by the underlying cash flow and risk profile
cannot be quickly and transparently verified. Fundamentally, rather than being able to purchase, for a
given price P, a bond of a specific quality in terms of risk and cash flow, the buyer would only be able to
purchase a bond whose quality is at most as good as what is being promised.8 Thus,
≥ [ℎ
(1 + )
=1
] ∗ 1−
At this point, Akerlof-style information asymmetry models discus the distribution of quality of the assets
on the market. Let us suppose that on average, quality of assets is inferior to what is promised. The
primary manifestation of quality in this model is the risk profile of the asset in question. Because the risk
profile of a security is usually the most difficult aspect of a financial security to verify independently, it is
the easiest aspect to misrepresent. Suppose that a particularly difficult to detect additional risk would
enter the securities market. Such that average quality is diminished:
≥ [ℎ
(1 + )
=1
] ∗ 1− (+ )
This B-class asset includes an additional risk factor (k), which is not detectible by the purchaser of the
securities at time of purchase, and which causes default risk to increase significantly. Under complete
and transparent information, its value would be considered far inferior to high-quality, AAA debt. Due to
information asymmetry in the market however, the additional risk is not being duly compensated by the
price paid for the asset. Furthermore, because of the proliferation of undetectable B-class assets in the
financial market, the average financial security which sells for a given price is in fact of a value lower
than the price paid, due to the risk profile of the asset in question. Here, the distribution of
undetectable B-class debt vis-à-vis A-class debt leads to a reduced average quality of debt, such that its
value is lower than the asking price of the debt instruments in question.
≥ [ℎ
(1 + )
=1
] ∗ [1− + ()]
And
0 ≤ = [ − )− ( − ] ≤ 1
Stated plainly, this fundamental misalignment between risk-weighted returns and prices, caused by
conflicts of interest at ratings agencies is a market failure. This failure caused massive losses of investor
confidence and widespread financial market instability. In a marketplace of rational actors such as
banks, hedge funds, and pension funds, buyers would shy away from the purchase of any security for
which the price is not justified by the cash flow and risk profile of the asset. According to the Akerlof
8Macho-Stadler, I., Pérez-Castrillo, J. D., 2001
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model’s prediction, once knowledge of k and of the distribution thereof becomes public, everyone
would sell, and the market for the asset would collapse.9
In this way, the effects of information asymmetry on the financial markets can be seen to cause first the
mis-valuation of asset-backed securities, followed by the evaporation of the market for asset-backed
securities. This is not the sort of incentive which promotes transparent, stable growth in financial
markets.
Why Asset-Backed Securities?
The 2008 financial crisis begs the following question: If the conflicts of interest and the information
asymmetry led to the market-failure of asset-backed securities, why did it not also lead to the market
failure of other types of securities, or to the total failure of the bond market overall, given that the
rating agencies are active in many markets simultaneously? After all, the potential for information
asymmetry to affect the financial markets exists in many places.
The answer, as one would expect with any information asymmetry scenario, involves novelty,
intransprency, and complexity in the market. Because of the complex and heterogeneous bundle-and-
slice techniques used in the construction of ABS and CDO, valuation thereof was considered among the
most obscure in the financial industry, meaning that only a select few economists at the largest
investment banks were actually able to value them accurately. In addition, elements of the valuation
function for ABSs classified as mortgage-backed securities (MBS) were known to be unreliable (by theinformed parties).10 Compounding the problem was the emergence of second-order derivatives such as
CDO-squared derivatives, which were created by bundling-and-slicing the already bundled-and-sliced
CDOs and ABSs.11 Furthermore, the same bundle-and-slice techniques made it difficult to determine
specific risk characteristics such as correlation between various assets.
Because the market for asset-backed securities was new, intransparent, and complex, it was clear to
those parties creating and valuing ABS and CDO that the market at large did not fully understand how to
evaluate the risk profiles of this new type of asset. It is here that the mis-valuation of the financial assets
was most plausible and where information asymmetry could most easily play a role.
9Macho-Stadler, I., Pérez-Castrillo, J. D., 2001
10Hull, J. C., 2009
11Vander Vennet, R., 2010
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The same is not true of simple bonds. In fact, in more simple areas of the financial markets, the risk
profile and valuation of financial assets can be estimated in-house. Furthermore, possibilities exist for
third-party estimations of valuation and risk.12
What to do Next?
Fundamentally, the problem has two elements which need resolution. First, information asymmetry and
incentive disparity inherent in the financial markets needs to be addressed. Theoretical models for
resolving information asymmetry prescribe proper incentive alignment between buyers and sellers, such
that sellers have the incentive to signal accurate and timely information to buyers.13
In the financial
markets, this signaling function is in fact, the fundamental role of the credit rating agency.
This brings up the second element of the problem. Namely, that the rating agencies ’ incentive to signal
accurate and timely information to the buyers’ market, is undermined by a conflict of interest.14 The
incentive of the rating agencies is thereby aligned to the issuer due to the agencies’ remuneration
structure. The classical and conventional solution would be to create incentive compatibility between
the signaling agent and the buyers’ market.15
In order to foster incentive compatibility, the classical academic model for this type of information
asymmetry, (which was originally designed for the used car market) would prescribe for the quality of
assets to be signaled via a warranty.16
In the automobile markets, this would mean that the buyer would
be protected by the seller for at least part of the risk of the car’s failure. In financial market practice,debt-related assets do not break down but rather, they enter default. This approach would thus mean
shifting part of the default risk to the agent. Unfortunately, such an arrangement would not be useful in
cases in which the issuing party enters bankruptcy, as would likely be the situation during episodes of
default on the financial markets.
An alternative form of incentive compatibility currently debated in academic circles involves the
introduction of malpractice fines for the rating agencies. This approach however, is non-viable chiefly for
two reasons. First, in a de jure sense, it is difficult to regulate rating agencies because they are not based
in Europe (outlined as an important factor in the April 2009 proposal for regulation of the European
12Berk, J. and DeMarzo, P., 2007
13Macho-Stadler, I., Pérez-Castrillo, J. D., 2001
14Official Journal of the European Union, 2009
15Macho-Stadler, I., Pérez-Castrillo, J. D., 2001
16Akerlof, G.A., 1970
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January 31, 2011 Maxens Berre Knowledge House Maastricht
Parliament and of the Council on Credit Rating Agencies).17
Moreover, legally speaking, opinions on the
quality of debt instruments can be considered to be protected as free speech. Second, in a de facto
sense, the imposition of penal regulation to the banking system would immediately generate staunch
opposition from both the banking lobby and many political parties, undermining the viability of any
legislative efforts on this issue.
While the need for independent, objective, and high-quality asset rating is recognized by the European
Parliament as a fundamental need for well-functioning markets, there seems to be no real consensus for
how to ensure such rating standards.18 Furthermore, the EU’s Regulation No 1060/2009, while having
several positive features, falls short of proper incentive alignment for three key reasons:
The regulation does not create a general obligation for financial instruments to be rated under
it.
Although the regulation addresses third-country credit rating agencies, jurisdiction over the
matter is not definite.
The regulation does not address the remuneration structure of credit-rating agencies.
Fortunately, the incentive-alignment problem may be easier to address than it would seem at first
glance. In fact, it can be addressed with minimal interference in the financial markets via a parallel rating
of securities.
The Public Financial Rating Agency
As we have seen, the conflict of interest in the remuneration scheme of the private and for-profit ratings
agencies has led to market failure in the market for rated financial assets.
A non-market actor who issues ratings in parallel to the private ratings agencies would fundamentally
transform the landscape of the market for ratings and rated securities. This is because if one of the
rating agencies would give a consistently non-conflicted rating to securities, the competing agencies
would find it difficult to justify a substantial deviation in ratings. Such an agency would have a deeply
positive effect on the incentive landscape in the marketplace. It would promote the right sort of
incentive compatibility in the ratings market by making any misevaluation of financial assets or their
underlying risk more evident, undermining the reputation of the rating agencies if and when conflicts of
interest bring them to misrepresent the value of the financial assets they are charged with rating.
17European Parliament, Committee on Economic and Monetary Affairs, 2009
18Ibid
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Examining the proposal as a coordination game, we can see that the private CRA is incentivized not to
misrepresent a financial asset’s value or risk. Indeed, a large unexplained deviation (positive or negative)
would lead to a diminishing of credibility for the private CRA vis-à-vis the pubic CRA. This would be the
case due to incentive differences for the two agencies. The fact that the conflict of interest in the privateagencies is widely known would lend credibility to the views of the public rating agency over that of a
private rating agency in the event of a significant divergence of rating.
Minor divergences would nevertheless be unlikely to attract significant attention. Indeed, it is currently
the case that rating agencies differ on the credit ratings they assign. Aware of the situation, private
rating agencies would exercise great care in rating financial assets in such a market environment.
Furthermore, private rating agencies can be expected explain the reason for any ratings divergences in
considerably greater detail than they would in the present situation. Overall, this change in incentives
and behavior on the part of private rating agencies would cause more accurate information to be
disclosed in the financial markets.
We next come to the question of what such a parallel rating agency should look like. Essentially, such an
agency should have two characteristics. First, it would need policy independence of a shape similar to
that of central banks, so that even politically strategic securities could be rated impartially. This would
foster the public rating agency’s credibility. Second, in order for the agency’s ratings to carry some
weight, pension funds based in Europe could be required to –at least take into account – the views of the
public rating agency on rated assets whilst deciding on their asset positions. While pension funds should
not be forced to base their outlooks and asset positions solely on the views of the public rating agency,
they should comment on their asset positions vis-à-vis the views of the public rating agency, as part of
their fiduciary-standard responsibilities. This should especially be the case during episodes of
public/private ratings divergences. Furthermore, any relationship between the public rating agency and
security issuing parties would be expressly banned and strictly watched.
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There also exists the issue of government treasury securities and other public-sector debt instruments.
Although in a formal sense, both independence and clear partition would exist between the agency and
the public-sector-debt-issuing party, the possibility of partiality concerning government treasury
securities may still exist and cannot be ignored. In an EU context, this would include EU-issued, ECB-
issued, and member-nation issued securities. In essence, there are two manners in which this issue may
be addressed. The public rating agency could either be barred from rating public-sector debt or else be
required to explicitly comment on the possible strategic partiality of its opinion in the situation.
Quis Custodiet Ipsos Custodes? Questions of Integrity:
Concerning questions of the integrity of the rating agency itself, the agency should be subject to an
environment of checks and balances similar to that of a central bank. The experience with central bank
independence and accountability has thus far generally shown good results vis-à-vis the maintenance of
integrity and neutrality.
To be specific about the nature of independence rules which could be applied, one may refer to the
ESCB’s independence rules. First, there is the issue of personal independence. While it is in fact the case
that European political authorities nominate the central bank governors, terms of office are fixed,
except in cases of serious misconduct or inability to complete the term, protecting the governors against
arbitrary termination, as established by article 14.2 of the Statute of the ESCB19
. Furthermore, “serious
misconduct” should be determined by judicial rather than political authorities. Next, is issue of
functional independence. A truly independent agency should be free to design its policy such that it
achieves its policy objectives.
20
In the context of an independent public CRA, this would mean that notonly should the agency not be pressured with respect to what ratings to assign, but it should also not be
pressured regarding the methodology for how it would arrive at its ratings.
Fundamentally, the agency’s integrity would be maintained by virtue of its policy independence. The
main idea is that conflicting influences on the public agency’s judgment would most likely emerge
regarding the issue of public-sector and politically strategic debt-issuances. Independence from the
political authorities who originally nominated the agency’s directors would insulate the agency from
such conflicts. It is the opinion of the ECB nevertheless, that policy independence is not a counterweight
to accountability. Independence and accountability are mutually reinforcing as long as clear andmeasurable policy objectives are [exogenously] outlined.21 In any case, policy independence can also be
made subject to a balance of powers, in a manner similar to the separate braches of a nation’s
government. Furthermore, is it also the opinion of the ECB that democratic control over the
19Bini Smaghi, L., 2007
20Ibid
21Ibid
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independent institutions needs to be maintained in order to prevent “excessive discretion and unclear
objectives, which risks creating political backlashes against independence.”22
Indeed, it is a fact that
while Germany’s monetary policy (i.e., its participation in Eurozone) is independent of the nominating
political authorities, it is overseen by the country’s judicial branch. Thus, the concept of independence
for a public financial rating agency would mean that while political authorities should be able to define
the agency’s mission and judicial authorities may evaluate whether or not this mission is being
effectively addressed, no one would tell the agency how to address its stated mission.
Conclusion
The information asymmetry aspect of the 2008-2009 financial crisis has taken the form of adverse
selection in the market for asset-backed securities, collateralized debt obligations, and derivatives
thereof. As in the classical adverse selection model, buyers were misled about the quality of the assets
on the market. In an environment in which buyers could not independently determine the quality of the
assets, private rating agencies colluded with asset-issuers to signal inaccurately-high asset quality.
Presumably the reason rating agencies had for doing so was the combination of conflict of interest due
to their remuneration structure and an opaque, non-transparent market for ABS and CDO.
While the classical response to this situation would be to align incentives via warranties, this is not
viable on the financial markets because such clauses could not be activated during bankruptcy.
Therefore, an effective solution to the problem would be the establishment of a policy-independent
public-sector rating agency to issue asset-quality signals in parallel to the private-sector rating agencies.
In this way, private CRAs would be incentivized to consistently issue accurate signals. The public CRA’sintegrity would be kept intact via the combination of operational, personal, and policy independence
with a system of judicial checks and balances modeled on central bank architecture.
22Ibid
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References:
Akerlof, G. A., “The Market for "Lemons": Quality Uncertainty and the Market Mechanism” The
Quarterly Journal of Economics, (Aug., 1970), Vol. 84, No. 3. pp. 488-500.
Berk, J., DeMarzo,P. “Corporate Finance” Pearson Education, Inc. 2007.
Bini Smaghi, L., “Central Bank Independence: From Theory to Practice”, Speech at Conference for Good
Governance and Effective Partnership, Budapest, Hungarian National Assembly, 2007.
European Parliament, Committee on Economic and Monetary Affairs, “I Report on the Proposal for a
Regulation of the European Parliament and of the Council on Credit Rating Agencies” (COM(2008)0704 –C6 0397/2008 –2008/0217(COD)) Rapporteur: Jean Paul Gauzès, 2009.
Fama, E.F., “Efficient Capital Markets: A Review of Theory and Empirical Work”, The Journal of Finance,
25(2), 1970, pp. 383-417.
Hull, J. C. “Options, Futures, and Other Derivatives” Pearson Education, Inc., 2009
International Monetary Fund “Global Financial Stability Report: Financial Market Turbulence Causes,
Consequences, and Policies” World Economic and Financial Surveys, Washington DC, October, 2007
International Monetary Fund “Global Financial Stability Report: Containing Systemic Risks and Restoring
Financial Soundness” World Economic and Financial Surveys, Washington DC, April, 2008
International Organization of Securities Commissions “Code of Conduct Fundamentals for Credit Rating
Agencies”, December, 2004
Macho-Stadler, I., Pérez-Castrillo, J. D., “An Introduction to the Economics of Information: Incentives and
Contracts” Oxford University Press, 2001.
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Official Journal of the European Union “EC Regulation No 1060/2009 of the European Parliament and of
the Council of 16 September 2009 on Credit Rating Agencies”, Brussels, September, 2009
Skidelsky, R. “Keynes, Return of the Master” Penguin Books Ltd., London, 2010
Vander Vennet, R. “Financial Crisis: 2007-2010” Speech at Ghent University, September, 2010.