Did Subjectivity Play a Role in CDO Credit Ratings?



  • Collateralized debt obligations (CDOs) are securities whose weaknesses helped bring on the 2008 financial collapse
  • Research suggests credit rating agencies (CRAs) knowingly stretched beyond their own models when they gave AAA ratings to shaky securities

The Study

"Did Subjectivity Play a Role in CDO Credit Ratings?" John M. Griffin and Dragon Yongjun Tang, Journal of Finance (August 2012)

The Issue

Collateralized debt obligations are the complex securities whose weaknesses helped bring on the financial collapse of 2008. Did credit rating agencies deliberately inflate their ratings of CDOs, or were they honest mistakes?

The Research

In the wake of the financial crisis, agencies like Moody’s and Standard & Poor's were accused of knowingly awarding AAA ratings to shaky securities, making them look safer than they really were. The agencies responded that they were victims of bad luck or bad financial modeling, but not deceit.

John Griffin, finance professor at the McCombs School of Business, examined whether or not credit rating agencies had ignored their own standards. With Dragon Yongjun Tang of the University of Hong Kong, he focused on collateralized debt obligations: derivative securities backed by everything from corporate bonds to mortgage loans. In the last years before the crisis, CDOs had rested more and more on risky subprime mortgages.

From Standard & Poor's, Griffin and Tang compiled data on 916 CDOs, issued from 1997 to 2007, with a combined principal value of $612.8 billion. They fed the data into S&P's own ratings model. Finally, they compared the model’s results to the actual ratings the agency had given to various portions, or tranches, of the CDOs.

On average, they found AAA-rated tranches were 12.1 percent larger than justified by the main model. For the weakest CDOs, those tranches were 26.8 percent larger. According to the credit rating agency's own model, the average AAA tranche deserved only a BBB rating. The researchers looked for other features that might justify the higher ratings, like experienced management, insurance or extra collateral. They found no relationship.

For investors who bought the CDOs, inflated ratings meant lower interest income, to the tune of at least $38.7 billion. But that wasn't the worst of it. By June 2010, only 29.1 percent of the CDOs were still rated AAA, while 45.2 percent had been downgraded to junk status. By comparison, 76.1 percent of corporate bonds issued in the same period kept their AAA ratings.

Practical Implications

The findings are relevant to any financial practitioner, says Griffin, whether they're buying securities or selling them. Before the crash, investors trusted CRAs and their ratings. Since the crash, CRAs have been trying to win that trust back. They've argued that they've learned from their mistakes and that their models are much improved. But his research suggests the CRAs stretched beyond their own models – and, warns Griffin, they could do it again.
"If, in fact, it's true that ratings were given out in an inflated fashion, perhaps to gain business, and that rating agencies weren't doing the best we could, then investors should be very careful not to rely on credit ratings," he says.

Since the credit rating agencies have not publicly admitted to much more than honest mistakes, he adds, the same problems that lead to the inaccurate ratings that caused the financial crisis may still be in place. In other words: Investor, beware.


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Faculty in this Article

John Griffin

Professor of Finance McCombs School of Business

John Griffin is the Arthur Anderson & Co. Alumni Centennial Professor of Finance at the McCombs School of Business and has been a visiting...

About The Author

Steve Brooks

In a quarter-century as a journalist, Steve Brooks has won two Neal awards for excellence in trade reporting and a Press Club of New Orleans award...

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