Inflated Ratings on Pre-Crisis CDOs: A Deeper Look

Abstract

Methodologies for analyzing and rating collateralized debt obligations (CDOs) backed by structured finance securities (SF-CDOs) were significantly flawed before the 2008 financial crisis. Two key issues were model risk and the absence of calibration to historical benchmarks. Although financial literature highlighted model risk as a potential problem starting in the mid-1990s, market participants— including the rating agencies—failed to properly address the issue. That partly explains why SF-CDOs that performed horribly during and after the financial crisis received high credit ratings before the crisis. With the 2009 update to its corporate CDO rating methodology, Standard & Poor’s was the first rating agency to embrace measures designed to mitigate model risk. Those measures included calibrating the methodology’s simulation model against external benchmarks and adding outside-the-model tests. Today, with the benefit of experience from the crisis, CDO investors should be wary of relying on any analytic methodology that does not specifically address model risk.