Research Highlights

Investors also liked those triple-A ratings

Quote icon
...much of the regulatory obsession with the conflict created by issuers paying for ratings is a distraction.
A common view of the financial crisis has it that, in the run-up to the meltdown of 2007-2008, credit rating agencies were essentially duped by the issuers of mortgage-backed securities, resulting in their over-rating the creditworthiness of these complex securities. NYU Stern Professor Thomas Cooley and coauthor Harold Cole argue that this view of credit rating agencies is greatly at odds with their historical role. For decades they were viewed as trusted arbiters of creditworthiness, and their opinions were sufficiently valued that they were used by regulators throughout the financial system to manage risk taking by market participants.

In “Rating Agencies,” Cooley, the Paganelli-Bull Professor of Economics at Stern, and Cole, an economics professor at the University of Pennsylvania, show that credit rating agencies have powerful incentives to issue well-informed ratings and that the ratings have value regardless of who pays for them. They argue that the regulatory reliance on credit ratings could have been a factor in inflated ratings for risky securities. Sophisticated investors with a preference for risk that was different from that mandated by regulations were happy with higher ratings on risky assets. These were made more likely as the supply of traditionally safe assets declined.

Cooley writes, “The experience of 2007-2009 suggests that restricted investors continued to invest in the claims rated by ‘inaccurate’ rating agencies even after it became clear to them that this was the case.” He and Cole believe that “much of the regulatory obsession with the conflict created by issuers paying for ratings is a distraction.”

While the regulatory reforms of the Dodd-Frank Act aim to remove regulatory reliance and put the onus on investors to certify the safety of the assets they hold, the authors conclude, it is far from clear how long this shift will take, how well it can be accomplished given the opaqueness of certain securities, and to what extent the securities industry will resist the change.