At could be dealt with. First of all what

At the end of this you will understand how credit ratings
agencies were responsible for the misunderstandings of risks that came along
with structured securities. To what extent the actions of these credit ratings
agency’s decisions affected the misunderstanding of these structured securities
and solutions to how these problems could be dealt with. First of all what is
structured securities, securities, securities are the grouping of assets for
example mortgages. In this instance this would generate finance through
mortgage interest payments. Investors will purchase these securities based on
its credit rating, credit rating acknowledges the risk & how well you can
recover from debt of the assets. These credit ratings are set by credit ratings
agencies. Now this is where the problem arises what happens if the credit
rating is underestimated or overestimated?

Discussion

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It is the credit ratings agency’s duty to provide credit ratings,
that being an investment grade triple A being the least likely to default and
best recoverability from debt and triple B- being the worst. Also the yield
rating of bonds varying from double B+ to C. They have high risk but as a
result of this they have high returns. However problems arose when credit
rating agency was falsely rating assets. Why they did this?

 This was done as it is
difficult to fully predict the likelihood of default or recoverability from
debt as conditions that affect the likelihood of default may change overtime
that are unexpected. Also there was alternative interest of credit rating
agencies, credit rating agencies would overrate assets so that clients and
potential clients, as a result they will decide to opt for their services
instead of a competitor. This was done as they are paid in order to provide a
credit rating & competitors drove them to provide false ratings as like any
company the main objective is to maximise profits, so this was done by
providing better ratings so they will have competitive advantage, as a result
of this it leads to a misinterpretation of risk associated with structured
securities. Another factor resulting from this over rated assets means you will
get investors who aren’t knowledgeable enough of the market investing & in
order to do so they will request for loans to finance for these structured
securities, this is also known as subprime lending. This is problematic because
as the structured securities credit rating is over graded when they default and
have poor recoverability these bad lenders will not be able to repay the loans
withdrawn. This will leave banks with insufficient funds creating further
problems.

How extent of actions affect the
outcome

However this result only occurs if credit rating agency rates
the structured securities way above the actually rating the security would
have. For instance if the structured security was rated an AA instead of A its
true rating, it’s not that significant of a change to cause such a significant
misinterpretation in terms of the risk of default and ability to recover from
debt.  Compared to a structured security
being assigned a grade of AA when in fact its true grade rating is a B. Which
would be much more misleading & credit agency could be held accountable for
the misinterpretation of the risks associated with structured securities. Also
dependant on the extent to which consumers have confidence in the economy. If
they lack confidence

 

Also could be due to external factors that would lead to a
misinterpretation of structured finance. For instance housing prices have
significant influence over the chance of default and recoverability. How?  Those who invested in structured securities
due to confidence as they have wealth in form of the price of their homes. This
would be done when house prices are rising. House owners will try taking
advantage of this appreciation in wealth by taking out a new loan in place of
their previous loan with lower interest payments. This loan would be granted to
house owner as there consistent appreciation of house pricing would provide
banks the confidence they will be able to repay the debt for the loan.  This additional money they will retain due to
lower interest rates will be used in hope to pay of the previous loan. Unfortunately
will no longer be able to pay loans back if they are unable to pay their
mortgage payments.  Therefore if the
security has a clause where they can possess assets you have in order to repay
the loan you have withdrawn it would leave borrowers bankrupt or financially
unstable as their houses would be taken from them and sold in order to raise
the finance for the loan given .

 Like any other good
when there is an increase in supply this would have a downwards push on price,
this occurs in order to discourage further supply of houses as there is less
profit incentive if prices are lowered. As house prices would drop this would
reduce confidence of consumers making them unlikely to purchase homes. As a
result this would cause the value of mortgages to drop & in turn the value
of structured securities to drop. Structured securities dropped as a result of receiving
few interest payments on mortgages as houses were reposed in order to finance
the loan given out by banks. As the value of mortgages depreciated as a result
of increased houses on the market the recovery rate was worsened making the
structured securities less reliable and this is how the devaluation of the
security came about.  This is something
credit rating agencies would not be able to interpret so cannot be fully blamed
for the misinterpretation of risks associated with structured securities.

 

However this is dependent on the extent to which house prices
would be affected as if demand for houses is inelastic. Inelastic demand is
when the responsiveness of demand has a less than proportionate change in
relation to price of the good or service. In this case an increase in supply
would lead to little or no change in house prices. In turn the value of
mortgage would retain a majority or even all of its value. House owners will
maintain confidence in the housing market resulting in why a majority or even some
cases the value or structured securities remains the same or relatively similar.
 So responsively structured securities
would retain a majority or even all of its value. So would not be a good
representative of why structured securities risks were misinterpreted.

Solution

A way the problem can be elevated would be a case where
credit rating agencies would have to be more open with their findings which they
use to determine the grade that they assign to structured securities.  For instance this was done when new
organisations were created in order to record statistics more efficiently so
there is less margin of error. This was done by SEC, they created national
recognised statistical rating organisation to take notes of these records. To
further the insurance that assets were correctly rated a new policy was
created. Where they would have to release the methods they used to conclude the
grade the structure securities deserve. This would reduce the incentive for
credit rating agencies to provide false ratings as it is easier to pinpoint who
is providing false information. Therefore would tarnish there reputation if
they was to provide false information as  consumers in response would avoid going to
that credit agency which they wouldn’t want as it reduce profits   so
would have to be more open on what factors determined the grade they provided
making then more transparent. This would reduce information failure and
maximise the welfare of consumers that are paying credit rating agencies for
their desired securities to be rated. In other words this would reduce the
misinterpretations of risk and ability to recover from debt of future structured
securities.