CFA Level I · CFA Level I Exam · Credit Risk
A structured product backed by a pool of loans is rated AAA by an agency that is paid by the product's sponsor. After the economy weakens, correlated defaults cause large losses on the AAA tranche. Which combination of limitations of credit ratings is most likely at work?
The best explanation is the difficulty of rating complex structures combined with the conflict of interest in the issuer-pays model. Models can understate default correlation in loan pools, and a sponsor-paid agency may be tempted to give favorable ratings, so a AAA tranche can suffer large losses.
- AExcessive rating frequency and a reliance on market prices rather than fundamentals
- BEvent risk from a sudden takeover and an issuer-specific litigation outcome
- CDifficulty in rating complex structures and a potential conflict of interest in the issuer-pays modelCorrect
Explanation
Complex structured securities depend on assumptions about default correlation that models may understate, so ratings can be wrong. The issuer-pays model creates a conflict of interest because the sponsor may favor agencies that give higher ratings. Event risk and excessive frequency do not describe losses from correlated pool defaults.
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