Put Credit Rating Agency's Money Where Its Mouth Is

We derive an optimal compensation contract that incentivizes a credit rating agency (CRA) to exert effort and issue unbiased ratings. The contract rewards CRA when its credit rating is matched by the subsequent bond performance and penalizes it otherwise. The optimal contract can be implemented by giving CRA options to buy bonds or credit default swaps. In a competitive environment, the contract is part of a procurement auction. Our empirical findings show that the credit rating industry remains problematic. Compared to incumbent CRAs, new entrants are consistently issuing more favorable ratings and are willing to rate more CMBS tranches