Abstract
Structured finance products are opaque and their ratings are unverifiable. Therefore, a credit rating agency (CRA) cannot credibly fully reveal its information about the quality of a rated structured finance project. Can reputation discipline the CRA? I introduce incomplete information about the CRA’s type: With some probability, it is a truthful type that always fully reveals its information. The (updated) probability that the CRA is truthful is its reputation. With only two project types and when the CRA’s reputation is high enough, an informationally-efficient equilibrium, where investors are fully informed, exists. If firms know the true CRA type however, this existence result fails. Moreover, with more than two project types, no matter how high the CRA’s patience level or its reputation, there is no informationally-efficient equilibrium. The many project types case is clearly the relevant case. Therefore, I conclude that the fear to lose reputation is not enough deterrent in the structured finance market.
Highlights
The recent financial crisis exposed widespread problems with rating structured finance products
I only discuss some of the earlier papers here: [1] discussed problems with rating timeliness, [2] discussed the “Credit Rating Crisis”, and [3] discussed the economics behind CDOs and showed problems with the credit rating agency (CRA)’s models
The main question this paper seeks to answer is: Will reputation ensure truth-telling in the structured finance market? If CRAs are truthful, there is a possibility that incomplete information about the project type would be eliminated
Summary
The recent financial crisis exposed widespread problems with rating structured finance products. CRAs insisted adamantly that their business is built on market participants’ trust and confidence in their ratings Their much-repeated claim is that CRAs can not afford to misrate products. Ratings have no credibility and market participants would ignore them, rendering them irrelevant This would deal a fatal blow to the CRAs. More generally, CRAs were thought to mitigate information asymmetries in financial markets. [4] identified a key feature of structured finance products: Their ratings are effectively unverifiable relative to bond ratings It showed that because of unverifiability, an equilibrium where CRAs fully reveal their information does not exist. I show that reputation is not potent enough to deter CRA from deviating from truth-telling, no matter how high their patience or initial reputation levels This contrasts with the standard story the CRAs were pushing before the crisis. The rest of the paper is organized as follows: Section 2 presents the infinitely repeated game with reputation, Section 3 presents the case of two projects but with firms informed of the CRA’s type, Section 4 presents the case of more than two projects and Section 5 concludes
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