Explain where credit ratings have failed in the past and what difficulties arise when they are relied on for investment decisions.
The idea
Ratings have failed in several ways. Structured-finance tranches rated AAA before 2007 suffered large losses when house prices fell, because the ratings did not capture correlation and systematic risk. The same letter therefore meant very different risk from a AAA corporate bond. Some defaulters, Enron being the usual example, held investment-grade ratings until shortly before they failed. Ratings also lag market prices. The issuer-pays model creates conflicts of interest and the chance of rating shopping. Rules that tie mandates and capital to ratings create cliff effects. A downgrade below investment grade forces selling, which deepens the fall. A sensible investor uses ratings as one input beside market signals and independent analysis, and never as the only credit work.
A practice question
Which feature of the traditional rating agency business model is most often cited as a source of conflict of interest?
- The agencies are owned by the governments of the countries they rate.Why not: The major agencies are private companies, not government-owned.
- The agencies publish ratings free of charge so they have no revenue.Why not: Revenue comes mainly from issuer fees; this is the source of the conflict.
- The issuer being rated usually pays the agency for the rating. - correct
- The ratings are secret and cannot be seen by investors.Why not: Ratings are public; the conflict arises from who pays, not from secrecy.
Under the issuer-pays model, agencies earn fees from the entities whose securities they rate. This can pressure agencies towards favourable ratings and allows rating shopping.
A harder one
A pension fund's mandate permits it to hold only investment-grade bonds. A large issuer is downgraded from BBB- to BB+, and many funds with similar mandates sell the bonds at the same time. This illustrates:
- a cliff effect from rating-based rules, which deepens price falls. - correct
- rating shopping, in which issuers choose the agency with the highest rating.Why not: Rating shopping is the choice of agency by the issuer; this scenario describes forced selling after a downgrade.
- a through-the-cycle rating, in which the rating ignores temporary conditions.Why not: TTC describes a rating philosophy; it does not explain forced selling at the investment-grade boundary.
- the recovery rate falling as the issuer approaches default.Why not: Describes loss severity at default, not forced selling triggered by crossing a rating threshold.
Rules that depend on ratings produce threshold effects: crossing from BBB- to BB+ forces many holders to sell at once, so prices overshoot and the downgrade becomes self-reinforcing.
The hardest tier
A AAA-rated corporate bond and a AAA-rated senior tranche of a mortgage securitisation have similar historical one-year default rates. Why was relying on the rating alone dangerous for the tranche?
- The tranche has no probability of default, so its rating adds no information.Why not: A senior tranche can default; it is not risk-free, which is exactly the lesson of the crisis.
- Its losses cluster in bad economic states, so it is far more exposed to systematic risk than the corporate bond. - correct
- The corporate bond has a lower recovery rate, which makes it the riskier of the two.Why not: The point is that tranche losses cluster with the economy, not that corporate recoveries are lower.
- Ratings for tranches use a different letter scale, so AAA means a lower credit quality.Why not: Both use the same scale; the problem is the same letter hides a different risk profile.
Both ratings reflect default or loss probability, but a senior tranche is a leveraged claim on correlated mortgages: it is fine in good times and suffers heavy losses together with the whole market in a crisis.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
Start free →More in External and Internal Credit Ratings
- Describe the scales used by external rating agencies, how ratings are assigned, and how a rating connects to the chance of default.
- Distinguish default probabilities that are conditional from those that are unconditional, defining each.
- Define the hazard rate, then apply it to find the unconditional probability that a credit asset defaults.
- Define the recovery rate and, with it, compute the loan's expected loss.
- Contrast ratings built on a point-in-time basis with those built through the cycle, and explain each.
- Outline the options that can be used in place of the credit ratings issued by rating agencies.
- Weigh internal ratings against external ones, noting the strengths of each.
- Describe a rating transition matrix, calculate with it, interpret it, and explain what it is used for.
- Outline how credit default swap spreads, bond prices and stock prices tend to move when a credit rating is upgraded or downgraded.