The credit rating crisis.

• Author: Benmelech, Efraim
• Position: Research Summaries

The credit crisis of 2008-9 was in many ways a credit rating crisis. Structured finance products, such as mortgage-backed securities, accounted for over $11 trillion dollars worth of outstanding U.S. debt. The lion's share of these securities were highly rated--for example, more than half of the structured finance securities rated by Moody's carried a AAA rating, the highest possible credit rating that is typically reserved for securities deemed to be nearly riskless. In 2007 and 2008, the creditworthiness of structured finance securities deteriorated dramatically: 36,346 Moody's rated tranches--tranches are a class of security with a prioritized claim against the collateral pool--were downgraded, and nearly one third of the downgraded tranches bore the AAA rating. In November 2007 alone, there were 2,000 downgrades and many were severe: 500 tranches were downgraded more than 10 notches. The ensuing confusion about the true value of these complicated securities, and the extent of exposure by financial institutions, incited a credit crunch with effects beyond subprime mortgage-related investments.

The Role of Credit Ratings in the Process of Securitization

Securitization is a broad term that encompasses several kinds of structures by which loans, mortgages, or other debt instruments are packaged into securities. The essence of securitization is pooling and tranching. After pooling a set of assets, the issuer creates several different classes of securities, known as tranches, with prioritized claims against the collateral pool. In a tranched deal, some investors hold more senior claims than others. In the event of default, the losses are absorbed by the lowest priority class of investors before the higher priority investors are affected. Naturally, the process of pooling and tranching creates some securities that are riskier than the average asset in the collateral pool and some that are safer.

The structured finance market is a "rated" market--the vast majority of securities issued are rated by at least one rating agency. Given the complexity of the underlying collateral and the asymmetric information between issuers of these securities and investors, credit ratings serve as a focal point for the quality of the securities.

The interaction between credit ratings and financial regulation was an important driver of growth in securitization markets. The extensive use of credit ratings in the regulation of financial institutions created a natural...