Confidence, Conflict, and Contagion: Behavioral and Structural Drivers of Inflated Credit Ratings During the Global Financial Crisis

This paper explains how Credit Rating Agencies (CRAs) assigned inflated ratings to mortgage-backed securities, collateralized debt obligations, and collateralized bond obligations, thereby amplifying the Global Financial Crisis and the housing bubble. Focusing on behavioral dimensions of decision-making within rating agencies, the paper shows how overconfidence, confirmation bias, and herd mentality interacted with structural incentives in the issuer-pays model. Overconfidence in quantitative risk models such as the Gaussian Copula created an illusion of precision, while confirmation bias led analysts to dismiss early signs of rising default risk. Groupthink and competition for market share reinforced these errors, leading to systematic inflation of AAA ratings. A formal framework models rating agency behavior as profit maximization under competing pressure of revenue, reputation, and behavioral distortion. The findings highlight that a full understanding of the crisis requires accounting for both economic incentives and the psychological distortions that shaped risk perception within CRAs.