Credit Risk Management Practice Exam

What role does the credit rating agency play in the securitization process?

1. Creating initial liabilities

2. Pooling and marketing the deal

3. Requiring subordination and enhancements for ratings

4. Collecting cash flows from investors

The correct answer is: Requiring subordination and enhancements for ratings

In the securitization process, the credit rating agency plays a crucial role in assessing the risk associated with the underlying assets being bundled together into securities. This assessment includes evaluating how the deal is structured, particularly regarding credit enhancements and subordination. The agency’s requirements for subordination and enhancements are essential in helping determine the credit rating assigned to the securities. When securities are issued based on a pool of underlying assets, higher-rated tranches (or classes) can attract more investors, as these are perceived to carry lower risk. The credit rating agency's insistence on certain structural features, such as subordination—where some tranches have a lower priority for claim on cash flows and losses—ensures that the risks are more clearly delineated among different classes of investors. These enhancements and subordination layers can protect senior bondholders from default risk, thus making the securities more appealing and secure to potential investors. The requirement for these measures not only aids in obtaining favorable ratings but also plays a crucial part in the overall functionality and stability of the securitization market.