Working Paper: CEPR ID: DP13534
Authors: Joel Shapiro; Jens Josephson
Abstract: The poor performance of credit ratings of structured finance products in the financial crisis has prompted investigation into the role of credit rating agencies (CRAs) in designing and marketing these products. We analyze a two-period reputation model in which a CRA both designs and rates securities that are sold both to investors who are constrained to purchase highly rated securities and investors who are unconstrained. Assets are pooled and senior and junior tranches are issued with a waterfall structure. When the rating constraint is lax, the CRA will include only risky assets in the securitization pool, serving both types of investors without any rating inflation. Rating inflation is decreasing in the tightness of the rating constraint locally. But rating inflation may be non-monotonic in the rating constraint globally, with no rating inflation when the constraint is lax or tight.
Keywords: credit rating agencies; reputation; structured finance
JEL Codes: G24; L14
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| tight rating constraints (E51) | increased discovery rates of opportunistic behavior by CRAs (G18) |
| increased discovery rates of opportunistic behavior by CRAs (G18) | influences incentive structure of CRAs (G38) |
| lax rating constraint (H60) | include only risky assets in securitization pool (G10) |
| include only risky assets in securitization pool (G10) | no rating inflation (E31) |
| tight rating constraints (E51) | rating inflation decreases (E31) |
| absence of rating inflation (E31) | efficient allocation (D61) |
| wealth of unconstrained investors (G19) | rating inflation increases (E31) |
| value of retaining safe assets (D14) | rating inflation increases (E31) |