3 The Credit Rating Crisis

By December 2008, structured finance securities accounted for over $11 trillion worth of outstanding U.S. bond market debt (35%). The lion’s share of these securities was highly rated by rating agencies. More than half of the structured finance securities rated by Moody’s carried a AAA rating—the highest possible credit rating. In 2007 and 2008, the creditworthiness of structured finance securities deteriorated dramatically; 36,346 tranches rated by Moody’s were downgraded. Nearly one-third of downgraded tranches bore the AAA rating. Both academics and practitioners have blamed structured finance for being, in part, responsible for the current credit crisis. In September 2007, Princeton economist Alan Blinder wrote, “Part of the answer is that the securities, especially the now-notorious C.D.O.s, for collateralized debt obligations, were probably too complex for anyone’s good. Investors placed too much faith in the rating agencies which, to put it mildly, failed to get it right. It is tempting to take the rating agencies out for a public whipping. But it is more constructive to ask how the rating system might be improved” (Blinder 2007). The goal of our paper is to inform economists about the credit rating crisis of 2007–8. We begin by describing what happened to structured finance credit rating during the crisis. We then try to explain why the ratings collapsed. Using detailed information on rating decisions made by Moody’s for every structured finance tranche, we document the ratings performance of structured finance products since 1983. We augment the evidence on structured finance ratings performance with data on rating transitions of all corporate bonds rated by Moody’s over the same period. The data on corporate bonds are used as a benchmark for the true distribution of credit ratings that are based on economic fundamentals. The comparison