Believe Only What You See: Credit Rating Agencies, Structured Finance and Bonds

The last financial crisis has raised many questions about the role of the Credit Rating Agencies (CRAs) in the structured finance market. Do CRAs mitigate information asymmetries in the structured finance market as they do in the bond market? In chapter 2 of this dissertation, I identify a key difference between structured finance products and bonds: the information underlying the rating of bonds is verifiable, but the information underlying the rating of structured finance products is practically unverifiable. I consider two game-theoretic models to study the information asymmetry mitigation role of the CRA. In the first model, the rating is unverifiable, and there is no equilibrium where the CRA fully reveals its information. In the second model, with some preset probability the rating is exogenously verified and the project's true default probability is publicly revealed. We show two things here first that as long as the verification probability is nonzero and the CRA's discount factor is high enough, there is an equilibrium where the CRA fully reveals its information. Second, that for all discount factors above a certain threshold, for every discount factor there exists a cutoff verification probability if the rating is verified above that threshold there exists an informationally-efficient equilibrium, if it is below that then there is not. Hence, in the model where ratings are verified enough as in the bond market, I find an informationally-efficient equilibrium where investors are always fully informed of the type of project they face. With no verification or with low verification with respect to the discount factor, as in the structured finance market, there is no informationally-efficient equilibrium, even when the game is infinitely repeated.;In chapter 2, I found that the CRA can not credibly fully reveal its information about the quality of the projects it rates when the ratings are unverifiable. In the model with unverifiable ratings an informationally-efficient equilibrium, where the investors are always fully informed about the quality of the project they face, did not exist. Chapter 3 analyses the infinitely repeated game with unverifiable ratings and asks: can fear to lose reputation discipline the CRA and induce it to behave truthfully? Reputation here is considered as incomplete information about the type of the CRA. With some probability, the CRA could be a truthful type that always truthfully reveals the information it has about the projects it rates. I analyze the game of chapter 2 between a sequence of short-run investors and short-run firms and a strategic long-run CRA. Nature selects a type for the CRA in the beginning of time and only informs the CRA of it. At every period, the (updated) probability that the CRA is of the truthful type is its reputation. In the model with only two types of projects, if the CRA's reputation is high enough, then there is an informationally-efficient equilibrium. But if there are more than two types of projects, then no matter how high the CRA's patience level or its reputation are, there is no informationally-efficient equilibrium. I also find that in the two types of projects case, if the firms are informed of the type of the CRA then there is no informationally-efficient equilibrium. The many types of projects case is clearly the relevant case to consider, therefore I conclude that the fear to lose reputation is not enough deterrent for the CRA in the structured finance market.