Financial intermediaries, such as credit rating agencies, have an incentive to maintain a public reputation for credibility amongst investors. However, in a market where credit rating agencies are interacting repeatedly with only a few issuers (sellers), they also have an incentive to develop a second, private reputation for leniency. We develop a dynamic model that analyzes how credit rating agencies can create such a double reputation. A key factor in our model is that issuers have privileged knowledge regarding the quality of rated assets compared to investors.In markets with a repeated interaction between issuers and rating agencies, this information asymmetry leads to dierent reputation updates following each rating process. We show that under certain conditions, it is optimal for the rating agency to inate ratings as a strategic tool to create a double reputation, whereby investors' beliefs regarding the credibility of the rating agency are higher than those of the issuers. Our results explain why rating ination occurred specically in markets for MBSs and CDOs and not in others. The results suggest that stronger regulation is needed in concentrated markets in order to avoid rating ination.

Financial intermediaries, such as credit rating agencies, have an incentive to maintain a public reputation for credibility amongst investors. However, in a market where credit rating agencies are interacting repeatedly with only a few issuers (sellers), they also have an incentive to develop a second, private reputation for leniency. We develop a dynamic model that analyzes how credit rating agencies can create such a double reputation. A key factor in our model is that issuers have privileged knowledge regarding the quality of rated assets compared to investors.In markets with a repeated interaction between issuers and rating agencies, this information asymmetry leads to dierent reputation updates following each rating process. We show that under certain conditions, it is optimal for the rating agency to inate ratings as a strategic tool to create a double reputation, whereby investors' beliefs regarding the credibility of the rating agency are higher than those of the issuers. Our results explain why rating ination occurred specically in markets for MBSs and CDOs and not in others. The results suggest that stronger regulation is needed in concentrated markets in order to avoid rating ination.JEL Classication: G24, D82, L15, C73

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We study the idea that seemingly unrelated behavioral biases can coevolve if they jointly compensate for the errors that any one of them would give rise to in isolation.We pay specific attention to barter trade of the kind that was common in prehistoric societies, and suggest that the "endowment effect" and the "winner's curse" could have jointly survived natural selection together. We first study a barter game with a standard payoff-monotone selection dynamic, and show that in the long run the population consists of biased individuals with two opposed biases that perfectly offset each other. In this population, all individuals play the barter game as if they were rational. Next we develop a new family of "hybrid-replicator" dynamics. We show that under such dynamics, biases are stable in the long run even if they only partially compensate for each other and despite the fact that the rational type's payoff is strictly larger than the payoffs of all other types.