Describe the Available Empirical Evidence of the Role Played by Credit Ratings in the Mortgage-Backed Securities Market

Describe the available empirical evidence of the role played by credit ratings in the Mortgage-Backed Securities market.

The meltdown, which began in 2007, severely disrupted the financial industry and led to the global economic downturn. The root of this financial crisis was predominantly due to the housing bubbles. In the years leading to the financial crisis, the interest rate was set at a low rate in the US with the aim to incentivise individuals to borrow to escalate spending. This resulted in US citizens taking subprime mortgages to obtain real estates. Many of these subprime mortgages were bundled together, creating novel financial instruments named mortgage-backed securities (MBS). By definition, MBSs are asset-backed securities, secured by multiple mortgages (Glickman, 2014). These MBSs were issued by government agencies and investment banks, and purchased by investors. However, since MBSs are backed by mortgages, which may not have sufficient information available in the market, investors may not possess adequate knowledge to estimate credit risks of these products required for investment decisions. Hence, credit rating agencies (CRAs) facilitate the investors in risk evaluation by giving ratings to MBSs. CRAs provide a rate that measures the ability of debtors to pay their debt (Bahena, 2010). There are three predominant CRAs in the growth of the MBS market, which are Moody’s, Standard and Poor’s (S&P), and Fitch Rating (He, Qian, and Strahan, 2012). Moreover, not only CRAs provide risk profile information, but their ratings could also impact the level of capital requirements in some types of financial institutions. Furthermore, by providing ratings to MBSs, CRAs could affect yields of tranches.

As MBSs are structured-finance products with a sophisticated securitisation process, it is difficult for many uninformed investors to assess risk of these products by themselves. Hence, CRAs help reduce asymmetric information in the market by providing credit ratings to the securities, making the market become more efficient. There is a discrepancy between rating corporate bonds and structured financed products. While corporate bonds’ cash flows and risks depend on the performance and prospects of the bond issuer firm, structured-financed products separate payments into prioritised claims, named ‘tranches’. These tranches absorb the underlying portfolio’s losses following seniority (He, Qian, and Strahan, 2012). Consequently, rating tranches is dependent on the quality of the collateral (which is

house mortgage for MBS), the seniority of tranches, and the degree of subordination of tranches (He, Qian, and Strahan, 2012). This implies that investors may find it easier to estimate the creditworthiness of corporate bonds, as company performance and prospects can be observed via available documents, such as financial statements and annual reports. On the other hand, structured-finance products’ rating relies on several attributes mentioned earlier alongside securities information that is protected from Regulation Fair Disclosures (Reg-FD) (He, Qian, and Strahan, 2011). Thus, by being able to directly reach issuers and access private information, CRAs could provide investors with ratings that reflect the creditworthiness of tranches of MBSs.