Opining on the securities is the role of the ratings agencies. The default risks on these securities and pricing should be correlated, but this is not always the case.

An example of these types of financial instruments is collateralized debt obligations (CDOs) and a financial structure of this type means that discrepancies or problems can be overlooked or are not automatically obvious in the underlying pool.

Small imprecisions can mean large default risk and incorrect pricing of instruments. The products and their locations underlying the instruments are also difficult to find or pin point. Therefore it is important for one to understand what the underlying fundamentals are when compared to corporate bonds.

The main ratings agencies are Standard and Poor’s, Moody’s and Fitch.

The creditworthiness of a product is distinguished by having a rating scale, which may be anything from AAA, AA, A, BBB etc. In America (2007); there were 37,000 top rated structured finance issues in the U.S. With the increase in issues, there was a loosening of criteria and pricing in some areas and this was widely seen as a reason for the financial downfall. An example of the potential problems was the mortgage crises around this time; where CDO’s were used to create securities that were rated at AAA. However, the underlying asset may not have been triple AAA rated. This meant that economic issues and unexpected defaults not previously priced in had a big impact.

The tranched system should be clear, that if a bucket is likely to default and it is high risk then similar rated securities will default at the same time. This will pay a higher coupon to an investor. As the pools are lower down the risk curve, they will pay a lower level of coupon or interest.