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Fault Lines by Raghuram G. Rajan

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CHAPTER SEVEN

Betting the Bank

ROUGHLY 60 PERCENT of all asset-backed securities were rated AAA during the lending boom, whereas typically less than 1 percent of all corporate bonds are rated AAA. How could this be, especially when the underlying assets against which the securities were issued were subprime mortgage-backed securities? Was this a sham perpetrated by the rating agencies?

Theory suggests it did not have to be a sham. In certain circumstances, a significant percentage of the securities issued against a package of low-quality loans can be highly rated.1 An example and some simple probability analysis can make the point. Suppose two mortgages, each with a face value of $1 and a 10 percent chance of total default, are packaged together. ...

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