Asset-Backed Securities (ABS): An Overview of Credit Ratings

The credit ratings of most asset-backed securities, a form of structured finance, are in the top investment-grade categories. The credit rating of the ABS may even be higher than that of the ABS sponsors. This is achieved through the use of special investment vehicles and credit enhancements, as well as through the use of supporting tranches.

Getting a top rating for an asset-backed security is important because the main buyers of asset-backed securities are institutional investors, such as pension funds and mutual funds and other fiduciaries of funds, who generally require, or are required by law, to invest in only investment-grade securities. Failure to get a top rating would severely limit the market for the security, so the issuers of asset-backed securities have developed methods for enhancing the credit of their security. This is done by consulting with the credit rating agency that will rate the security.

The fees that the credit rating agencies earn through these consultations is usually much higher than the agencies receive for rating bonds. There has been recent criticism about this cozy arrangement concerning mortgage-backed securities (MBS) and their credit ratings, because many of these securities were severely downgraded because of the many defaults on the underlying subprime mortgages. Many critics believe that the credit rating agencies were biased in their ratings because they were earning big fees from the consultations, and were more lenient in their ratings criteria, since they competed for the business of the MBS issuers.

Credit ratings for ABSs are established by reviewing the structure of the deal and the parties involved, the nature and performance history of the collateral, the special purpose entity used to securitize the collateral and issue the resulting notes, and by an analysis of the credit enhancements used to protect the senior tranches against default.