Monday, June 08, 2009

Ratings shopping 

Since June 2007, the creditworthiness of structured finance products has deteriorated rapidly. The number of downgrades in November 2007 alone exceeded 2,000 and many downgrades were severe, with 500 tranches downgraded more than 10 notches. Massive downgrades continued in 2008. More than 11,000 of the downgrades affected securities that were rated AAA. This paper studies the credit rating crisis of 2007-2008 and in particular describes the collapse of the credit ratings of ABS CDOs. Using data on ABS CDOs we provide suggestive evidence that ratings shopping may have played a role in the current crisis. We find that tranches rated solely by one agency, and by S&P in particular, were more likely to be downgraded by January 2008. Further, tranches rated solely by one agency are more likely to suffer more severe downgrades.
Abstract of a new paper by Benmelech and Dlugosz. Ungated copy appears to be here. If it turns out, as seems to be from this article, that ratings agencies were competing for business by fudging the grades they gave to CDOs and SIVs, regulators had best start thinking about whether they should rely on those ratings in deciding on, for instance, what constitutes acceptable collateral. For example, the new lending facility by the Fed against commercial mortgage-backed securities requires the collateral to be rated by TWO agencies.