Financial Risk Manager Part 1
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During the period leading up to the 2007-2008 financial crisis, credit rating agencies were frequently observed to provide overly positive ratings and forecasts for structured financial assets. This practice was seen as problematic and indicative of a certain agency problem. What was the specific agency problem that was at play in this scenario?
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A
Structured financial assets initially had very low demand, and credit rating agencies wanted to push that demand up.
B
Credit rating agencies were under considerable pressure from the federal government to issue favorable ratings that would stir the economy and lead to growth.
C
Credit rating agencies depended heavily on sophisticated mathematical models, which failed to accurately predict the risk of these structured financial assets.
D
Credit rating agencies would get paid by originators of structured financial assets for their work, and also made more money than they would otherwise have made from rating corporate bonds.
Explanation:
The correct answer is D because this describes the classic agency problem where credit rating agencies had a conflict of interest. They were paid by the very issuers whose products they were rating, creating an incentive to provide favorable ratings to maintain business relationships and generate higher fees. Structured financial assets (like mortgage-backed securities) were more complex and profitable for rating agencies than traditional corporate bonds, creating additional financial incentives for favorable ratings. This conflict of interest led to systematically inflated ratings that failed to accurately reflect the true risks of these securities, contributing significantly to the 2007-2008 financial crisis.
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