Where Did the Risk Go? How Misapplied Bond Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruptions

Joseph R. Mason, Josh Rosner
2007 Social Science Research Network  
Many of the current difficulties in mortgage-backed securities (MBS) and collateralized debt obligations (CDOs) can be attributed to a misapplication of agency ratings. Changes in mortgage origination and servicing make it difficult to evaluate the risk of MBS and CDOs. We show that the big three ratings agencies are often confronted with an array of conflicting incentives, which can affect choices in subjective measurements of risk. Of even greater concern, however, is the fact that the
more » ... of creating MBS and CDOs requires the ratings agencies to arguably become part of the underwriting team, leading to legal risks and even more conflicts. We analyze the fundamental differences between rating structured finance products like MBS and CDOs and traditional products like corporate debt. We show that the inefficiencies of rating MBS and CDOs are leading investors to discount U.S. markets. We conclude by providing several policy implications of our findings.
doi:10.2139/ssrn.1027475 fatcat:6wjkvk5dq5f4pag5le5tzh7zsu