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Discretionary ratings and the pricing of subprime mortgage-backed securities

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  • Lugo, Stefano

Abstract

Using a dataset of Home Equity Loan securities issued up to June 2007 and rated by Moody’s and/or S&P, this paper investigates how discretionary ratings are priced by the market. To this end, a measure of relative rating inflation (Rating Bias) observable at issuance is proposed. The way Rating Bias is priced changes significantly between Investment Grade (IG) and Speculative Grade (SG) securities. Rating Bias is only partially discounted for IG tranches, whereas it is correctly priced for SG ones. Less sophisticated institutional investors are often restrained from investing in securities rated lower than triple-A, double-A or A; however, these alternative thresholds do not appear to play a role as relevant as that of the IG–SG boundary. Rating Bias is also found to have an asymmetric impact on spreads: the relevance of actual over expected ratings is greater for tranches receiving evaluations that are higher (rather than lower) than expected. Taken together, these pieces of empirical evidence point toward ratings-based regulation as an important explanation for the observed mispricing of structured finance products.

Suggested Citation

  • Lugo, Stefano, 2014. "Discretionary ratings and the pricing of subprime mortgage-backed securities," Journal of Banking & Finance, Elsevier, vol. 48(C), pages 248-260.
    • Handle: RePEc:eee:jbfina:v:48:y:2014:i:c:p:248-260
    DOI: 10.1016/j.jbankfin.2014.06.021
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    References listed on IDEAS

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    Cited by:

    1. Abad, Pilar & Ferreras, Rodrigo & Robles, M-Dolores, 2019. "Informational role of rating revisions after reputational events and regulation reforms," International Review of Financial Analysis, Elsevier, vol. 62(C), pages 91-103.
    2. Solomon Y. Deku & Alper Kara & Artur Semeyutin, 2021. "The predictive strength of MBS yield spreads during asset bubbles," Review of Quantitative Finance and Accounting, Springer, vol. 56(1), pages 111-142, January.
    3. Lugo, Stefano, 2019. "Insider ownership and the cost of debt capital: Evidence from bank loans," International Review of Financial Analysis, Elsevier, vol. 63(C), pages 357-368.
    4. Deng, Kaihua & Qiao, Guannan, 2022. "Triple A default," Pacific-Basin Finance Journal, Elsevier, vol. 74(C).

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    More about this item

    Keywords

    Credit rating; Subprime; Rating inflation; Regulation; Yield spread;
    All these keywords.

    JEL classification:

    • G01 - Financial Economics - - General - - - Financial Crises
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • G24 - Financial Economics - - Financial Institutions and Services - - - Investment Banking; Venture Capital; Brokerage
    • G38 - Financial Economics - - Corporate Finance and Governance - - - Government Policy and Regulation

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