Abstract:
Structured finance products are opaque and their ratings are unverifiable. Therefore,
a credit rating agency (CRA) cannot credibly fully reveal its information about the
quality of a rated structured finance project. Can reputation discipline the CRA? I
introduce incomplete information about the CRA’s type: With some probability, it is
a truthful type that always fully reveals its information. The (updated) probability
that the CRA is truthful is its reputation. With only two project types and when the
CRA’s reputation is high enough, an informationally-efficient equilibrium, where
investors are fully informed, exists. If firms know the true CRA type however, this
existence result fails. Moreover, with more than two project types, no matter how
high the CRA’s patience level or its reputation, there is no informationally-efficient
equilibrium. The many project types case is clearly the relevant case. Therefore, I
conclude that the fear to lose reputation is not enough deterrent in the structured
finance market.
