Since the 2007-2008 financial turmoil originated in the market for subprime mortgage-backed securities, much attention has been recently at the flaws of the securitization process and particularly at the failures of the rating agencies (CRAs), which played a key role in this process (see for instance the Financial Stability Forum Report, 2008, and International Monetary Fund, 2008). Two issues fare prominently in this respect.
First, since 2007 even very highly-rated structured debt products have performed very poorly: the value of AAA-rated mortgage-backed securities (as measured by the corresponding credit default swaps prices) fell by 70 percent between January 2007 and December 2008. This suggests that their initial ratings greatly understated the risk of structured debt securities. Such “ratings inflation” is central to the understanding of the crisis: insofar as many investors naively based their investment in these securities mainly or solely on inflated credit ratings, these led to a massive mispricing of risk, whose correction later detonated the crisis.
Second, in the process of securitization and rating much detailed information about the risk characteristics of the underlying assets was lost. Given the way they are designed, ratings provide very coarse and limited information about these characteristics. This information loss is particularly serious in view of the heterogeneity of the collateral and the great complexity of the design of structured debt securities. Once a scenario of widespread default materialized, this detailed information would have been essential to identify the “toxic assets” in the maze of existing structured debt securities, and to price them correctly. Absent such information, structured debt securities found no buyers, and their market froze. So the information loss involved in the process of securitization and rating is largely at the source of the illiquidity that plagues securities markets since the crisis broke out.
In this paper, we draw on existing research to assess the likely causes for these two failures of rating agencies in the securitization process – ratings inflation and information loss due to their coarseness and review the policies that may be adopted to correct or mitigate them in the future. The most obvious motive for the inflation of credit ratings is an incentive problem: CRAs are paid by issuers, so that their interest is more aligned with that of securities’ issuers than with that of investors. In this respect, CRAs are not unique: a similar conflict of interest also exists for other “financial gatekeepers”, such as auditing companies, but as we shall see regulation has been much more lenient with credit rating agencies. Moreover, in the case of ratings the problem is exacerbated by the possibility for issuers to engage in “rating shopping”, by soliciting only the most favourable rating among those potentially available from a set of competing agencies.
The reason for disseminating only coarse information when issuing structured debt securities is less obvious, since one would expect the provision of detailed public information to reduce the rents of informed traders, and thereby to enhance secondary market liquidity. This should in turn increase the issue price of the securities, leading issuers to ask CRAs to provide the most detailed assessment of the risk characteristics of their issues, or else complement their ratings with any additional data necessary for such assessment. But arguably issuers saw an even larger benefit in providing relatively coarse information: that of expanding the primary market of structured debt securities, by making them palatable also to investors who could not easily process complex information. By providing little information to all, they levelled the playing field so that unsophisticated could buy these securities without losing money to sophisticated ones, and thereby attracted the former into their primary market. Indeed, issuers and rating agencies grasped the counterintuitive principle that, to market very complex securities to a clientele that includes relatively unsophisticated investors, less rather than more disclosure enhances market size and liquidity. However the current crisis shows that the implied information loss can have dire consequences for market liquidity further down the road, if and when the neglected information becomes price relevant.
