Traditional unsecured credit investors who are wading into the structured finance market should be wary of taking ratings at face value, the Bank for International Settlements warns in a recent report. The BIS said identical ratings on an unsecured credit and a structured product can mask significant differences in risk, potentially leading to a mismanagement of risk by investors who adopt a so-called buying the rating approach.
Structured finance tranches can be significantly riskier than individual credits with identical ratings, as they include additional sources of risk such as correlation risk and skewness effects. Ratings, meanwhile, are based on expected-loss and probability-of-default metrics, and it is up to individual investors to do their own analysis on additional risk metrics, the report states.
While experienced structured finance investors interviewed by the BIS do not rely solely on ratings, the authors of the BIS report observe as structures get marketed to a wider audience, it becomes more likely investors only dabbling in the market will buy these instruments without fully understanding the risk profile. In addition, market conditions are due to become less benign, as default rates and credit spreads retreat from historic lows, adding to the potential for pain if risks are mispriced.
The report is called "The Role of Ratings in Structured Finance: Issues and Implications."