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Title: Credit Ratings and Structured Finance

Author(s): Jens Josephson and Joel Shapiro

Publication Date: February 2019

Keyword(s): Credit rating agencies, reputation and Structured finance

Programme Area(s): Financial Economics

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.

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Bibliographic Reference

Josephson, J and Shapiro, J. 2019. 'Credit Ratings and Structured Finance'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=13534