An Academic Finance Paper that the RBC Will Enjoy Reading

Did the ratings agencies play favorites in rating MBS bond risk?  Were they more likely to grant “AAA” ratings to larger issuers of MBS bonds?   Phil Strahan and his co-authors say “yes”.  Here is their abstract:

“We examine whether rating agencies (Moody’s, S&P, and Fitch) reward large issuers of mortgage-backed securities, who bring substantial business, by granting them unduly favorable ratings. The initial yield on both AAA-rated and non-AAA rated tranches sold by large issuers is higher than that on similar tranches sold by small issuers during the market boom years of 2004-2006. Moreover, the prices of MBS sold by large issuers drop more than those sold by small issuers, and the differences are concentrated among tranches issued during 2004-2006. We conclude that large issuers receive more favorable ratings and that the market prices the risk of inflated ratings, especially during booming periods.” 

For a copy of their technical paper click here.  Page 2 offers a subtle discussion for why MBS assets are different than other assets and thus pose challenges on  relying on free market competitive forces for achieving accurate risk assessment.

Author: Matthew E. Kahn

Professor of Economics at UCLA.

3 thoughts on “An Academic Finance Paper that the RBC Will Enjoy Reading”

  1. Matthew, have you ever thought about getting a job with a ratings agency? I think that you’d be a good fit.

  2. Is the blessed ratings agencies’ special position with respect to credence and liability statutory or just regulatory fiat?

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