Bayesian Persuasion in Credit Ratings, the Credit Cycle, and the Riskiness of Structured Debt Alexander David Maksim Isakin * November 2014 Abstract We present a new theoretical model that sheds light on why CDO tranche spreads widen during credit crunch periods. In the model, firms’ risk taking is endogenous and credit ratings arise from an investigation process that is designed to maximize the proportion of firms with high ratings (Bayesian persuasion). We show that the rating agency changes rating standards over the business cycle. If the economy enters a recession, the deteriorating quality of fundamentals implies that debt issued in booms may not be incentive compatible with low-risk behavior. In this case, the rating agency undertakes a more stringent rating investigation to increase the precision of ratings and hence to reduce the cost of capital with good ratings. Highly rated firms can only realize the benefits of more precise ratings by calling existing debt and issuing lower cost debt. This may not be possible during a credit crunch, and hence the resulting high risk strategy by firms in such periods implies that senior tranches, which are nearly riskless at the time of issuance, get seriously impacted. We find support for this hypothesis in the data. ∗ Both authors are from the University of Calgary, Haskayne School of Business. We thank Curtis Eaton and seminar participants at the Canadian Economic Association Meetings and the Alberta Finance Institute Conference for helpful comments. Address: 2500 University Drive NW, Calgary, Alberta T2N 1N4, Canada. E. Mail (David): adavid@ucalgary.ca. E.Mail (Isakin) misakin@ucalgary.ca. 1