You Would’ve Thought They Worked for Moo-dy’s
posted by Sarah Lawsky
If you were deciding whether to loan someone money, it would be very useful to know the chances that the person would pay you back. (For example, the higher the chance they would default, the more you would charge them to borrow the money.) Rating agencies–two dominant agencies are Moody’s and Standard and Poor’s (or “S&P”)–are supposed to provide lenders with that information. The less the risk of default on a particular financial instrument, the higher the rating. The rating agencies predict (or model) the risk, and if the rating agencies don’t do a good job, financial instruments’ market prices don’t reflect their actual value.
As others have discussed in a much more nuanced fashion, rating agencies may be partly to blame for the recent financial crisis. The agencies appear to have been more concerned about keeping their clients (those who issued the financial instruments) happy than rating financial instruments accurately. The ratings were too high, prices were too high, lenders and other purchasers of financial instruments didn’t anticipate default…and (to oversimplify) there’s your financial crisis.
But there appears to have been another market failure associated with rating agencies–a totally unexploited chance for profit.
Recent reports have drawn attention to an IM exchange between two S&P employees:
Employee One: btw – that deal is ridiculous
Employee Two: I know right…model def does not capture half of the [risk]
Employee One: we should not be rating it
Employee Two: we rate every deal
Employee Two: it could be structured by cows and we would rate it
"Well, that was a missed opportunity."
And the last name of Employee Two? Mooney. I’m not kidding. What else would you expect to get when you combine cows and cash?
Image: Sunfox, Three Cows (Flickr.com); used under a Creative Commons Attribution-Share Alike 2.0 Generic license
June 2, 2009 at 12:11 pm
Posted in: Corporate Finance
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Responses (1)
A.J. Sutter - June 2, 2009 at 5:47 pm
The apparent self-evidence of the idea of that if someone is more likely to default you should charge them more money for a loan has long intrigued me. As the Talmud says, “Let your ears hear what your mouth is saying” — if they are more likely to default to begin with, charging them higher interest seems to make their default even more likely.
Is there empirical evidence that higher-interest rate loans have default rates no worse than other loans? How about more specifically, any evidence for default rates monotonically increasing (or not) with interest rate charged?
If default rates don’t monotonically increase with interest rates, then isn’t the ostensible reason for charging higher interest rates falsified? If they do monotonically increase with interest rates, then isn’t there an element of self-fulfilling prophecy in the reason given for higher interest rates? And if default rates are low enough that in the aggregate, loans to high risk borrowers can be profitable for the lenders, might there not be some lower rate of interest where lenders could still make money, but the lives of fewer borowers would be churned up by default? (You could call that a socially responsible interest rate.)
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