PT - JOURNAL ARTICLE AU - John Hull AU - Alan White TI - Ratings Arbitrage and Structured Products AID - 10.3905/jod.2012.20.1.080 DP - 2012 Aug 31 TA - The Journal of Derivatives PG - 80--86 VI - 20 IP - 1 4099 - https://pm-research.com/content/20/1/80.short 4100 - https://pm-research.com/content/20/1/80.full AB - An apparent breakdown of the credit rating process for structured products is widely believed to have played a major role in the run-up and subsequent collapse of the market for mortgage-backed securities. In this article, Hull and White observe that the ratings criteria used by two of the ratings agencies (Standard and Poor’s and Fitch) are supposed to reflect the probability of default but not the possible severity of the investor’s loss in a default, which introduces anomalies into the rating process. For example, diversification of a credit portfolio across issuers with equal credit quality increases the chance of a default by one of them—thus lowering the rating on the portfolio—even though the loss is reduced if there is a default. The default-risk-only criterion is shown to fail the requirements for a risk measure to be “coherent,” which means that the structuring process allows for profitable credit arbitrage.TOPICS: Derivatives, MBS and residential mortgage loans, financial crises and financial market history