Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Partnoy on Rating Agencies

Frank Partnoy has an interesting paper
entitled “How And Why Credit Rating Agencies Are Not Like Other
Gatekeepers”. I have talked about rating agencies on this blog
here. Partnoy brings several new insights into this discussion.

  • “Before the 1970s, when the Securities
    and Exchange Commission created the NRSRO designation and various regulations
    began to depend on NRSRO ratings, credit rating agencies made
    money by charging subscription fees to investors, not ratings fees to
    issuers. In
    contrast, today roughly 90 percent of credit rating agencies’
    revenues are from
    issuer fees.”
  • “As of early September 2005, Moody’s market
    capitalization was more than $15 billion … Moody’s share price
    trades at a significantly higher multiple than the typical publicly
    traded gatekeeper, such as an investment bank.”
  • “Although Moody’s might say that it is in the financial
    publishing business,
    market participants do not believe it. Moody’s is substantially
    smaller than the
    other major financial publishers and generates less revenue than they
    do, but it
    has a much higher market capitalization. …
    Investors will pay five times
    more for a dollar of Moody’s revenue than for a dollar of the
    revenues of Dow
    Jones or Reuters. Each Moody’s employee is associated with ten times
    more market
    value than each Dow Jones or Reuters employee. By virtually any
    financial measure, Moody’s has a much more valuable franchise than
    other financial publishing
    firms and is much too profitable to be considered a financial publisher. If
    Moody’s were in the same business as financial publishing firms, one
    would expect
    these ratios to be close.”

Partnoy also has an extended discussion criticizing the way ratings
agencies rate CDOs and argues that CDOs are there only
because of rating arbitrage: “Put another way, credit rating
agencies are providing the markets with an opportunity to arbitrage the credit
rating agencies’ mistakes”. I would not agree with this part of
Partnoy’s analysis. The
intense competition between the two
major rating agencies to produce better CDO rating models would rather
suggest that rating arbitrage is a passing phase in a maturing

But Partnoy has written a very informative and thought provoking
paper on rating agencies. I entirely agree that the time has come to
eliminate the regulatory use of ratings completely.


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