Does the Market Understand Rating Shopping? Predicting MBS Losses with Initial Yields

Abstract

We study rating shopping on the MBS market. Outside of AAA, losses were higher on single-rated tranches than multi-rated ones, and yields predict future losses for single-rated tranches but not for multi-rated ones. Conversely, ratings have less explanatory power for single-rated tranches. These results suggest that single-rated tranches have been ‘shopped,’ whereby pessimistic ratings never reach the market. For AAA-rated MBS, by contrast, 93% receive two or three such ratings, and those ratings agree 97% of the time. This ratings convergence suggests that agencies ‘catered’ to investors, who could not purchase a tranche unless it has multiple AAA ratings.