We all know that the 2008 financial crisis began with the collapse of market for Mortgage-Backed Securities (MBS) Collateralized Debt Obligations (CDO and CDO-squared). What many people never gave much thought to is the fact that more than 90% of these financial products enjoyed a AAA rating despite being based on sub-prime real-estate lending.
Why was this? In short, its because the ratings agencies (Fitch, Moody's and Standard & Poor) all get paid by the issuer of the security. This is a conflict of interest if ever there was one. In economist-speak, we would call this "A Market for Lemons" or "Adverse Selection". Ultimately, the MBS and CDO markets turned out to be as reliable as the second-hand car market.
This paper offers an explanation for the 2008-2009 financial crisis using an adverse selection model for the asset-backed security and collateralized debt obligation markets, in which more than 90% of assets enjoyed a AAA rating despite being based on sub-prime real-estate lending. Because the classical adverse selection incentive-alignment response would be ineffective during episodes of bankruptcy in the financial markets, alternate arrangements for incentive-alignment are necessary. A public-sector rating agency would align the incentives of private-sector credit-rating agencies via a reputation effect. This public agency would in-turn maintain its integrity and neutrality via central-bank-style policy independence architecture.-----------------------------------------------------------
About the Author:
Max Berre is an economist at the EDHEC-Risk Institute (Ecole Des Hautes Etudes Commerciales du Nord) who has worked as a sovereign debt expert at the Inter-American Development Bank in Washington and has taught financial economics at Maastricht University in the Netherlands.