Credit Ratings in Structured Finance and the Role of Systemic Risk

This paper explores the implications of systemic risk in Credit Structured Finance (CSF). Risk measurement issues loomed large during the 2007-08 financial crisis, as the massive, unprecedented number of downgrades of AAA senior bond tranches inflicted severe losses on banks, calling into question the credibility of Rating Agencies. I discuss the limits of the standard risk frameworks in CSF (Gaussian, Single Risk Factor Model; GSRFM), popular among market participants. If implemented in a ‘static' fashion, GSRFM can substantially underprice risk at times of stress. I introduce a simple ‘dynamic' version of GSRFM that captures the impact of large systemic shocks (e.g. financial meltdown) for the value of CSF bonds (ABS, CDO, CLO, etc.). I argue that a proper 'dynamic' modeling of systemic risk is crucial for gauging the exposure to default contagion (‘correlation risk'). Two policy implications are drawn from a 'dynamic' GSRFM: (i) when rating CSF deals, Agencies should disclose additional risk information (e.g. the expected losses under stressed scenarios; asset correlation estimates); and (ii) a ‘point-in-time' approach to rating CSF bonds is more appropriate than a ‘through-the-cycle' approach