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FRM Part I · FRM Exam Part I · External and Internal Credit Ratings

A risk analyst reviews criticisms of external ratings for structured finance products during the 2007-2009 crisis. Which statement most accurately describes a recognized limitation that contributed to rating failures on these products?

Structured product ratings relied heavily on correlation and model assumptions, so AAA tranches were far more exposed to systemic downturns than AAA corporate bonds. Identical letter grades therefore did not imply identical risk, which is a central criticism of ratings on structured finance.

  1. AA given rating on a structured product carried the same sensitivity to systematic risk as the same rating on a corporate bond
  2. BStructured product ratings were too volatile relative to corporate ratings before the crisis
  3. CAgencies were not paid by issuers, so they lacked access to deal information
  4. DRatings were highly sensitive to correlation and model assumptions, so AAA tranches were vulnerable to systemic downturns far more than similarly rated corporate bondsCorrect

Explanation

Structured tranches depend on default correlation and model assumptions, so in a systemic downturn highly rated tranches suffered large downgrades and losses, unlike similarly rated corporates. The claim of equal systematic sensitivity is the key misconception. Agencies were in fact issuer-paid, not unpaid.

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