Credit Ratings in Structured Finance: Some Lessons
from the Current Credit Crisis and Beyond

Abstract

This article reviews the relevant facts and discusses the main issues that have loomed large in the structured finance credit rating crisis of 2007–2008. Two key features have played a critical role: risk substitution (from diversifiable to systemic exposure) and rating fragility. The main focus of the article is the enormous number of downgrades of senior AAA bond tranches, in the effort to explain this unprecedented burst of (downward) rating volatility. The rating of structured finance products poses far greater challenges than standard corporate bond practice, as parameter uncertainty and estimation/measurement errors can have a much larger impact on their (credit) risk (e.g., rating grades). Unanticipated systemic risk shocks can greatly amplify these margins of error. The adverse impact is greatest for the structured finance instruments least exposed to actual credit risk (AAA senior bond tranches). Moreover, as the credit crisis was approaching, senior bond tranches were priced as if market participants were neglecting the risk that large macro-shocks might downgrade the quality of structured finance collateral pools.