Rating Competition and Structured Finance

Abstract

As subprime mortgage losses cascade throughout the global financial system, attention has turned to the structure and performance of the bond rating industry. Faulty ratings on securities backed by subprime mortgages are believed responsible for billions of dollars in losses. This article argues that any such faulty ratings are due in part to conflicts inherent in the issuer-pays rating agency business model. Such conflicts, when combined with existing structured finance practices, have led to widespread rating shopping. Efforts to increase competition among rating agencies may exacerbate the problem unless fundamental changes occur in the structured finance area, particularly in attitudes toward unsolicited ratings. Competitive forces will not improve the quality of ratings until every competitor has the ability to offer an unsolicited opinion. Regulatory authorities must insist that future structured finance transactions be sufficiently transparent in their structure and in the details of the underlying collateral that any rating agency may offer a credible opinion, regardless whether it was selected by the originator.

TOPICS: Exchanges/markets/clearinghouses, legal and regulatory issues for structured finance, legal/regulatory/public policy