Q: How did Wall Street manage to convince the rating agencies to slap investment grade ratings on Junk?

A: They had cheat codes !

Here is Gretchen Morgenson and Louise Story in today’s NYT:

“One of the mysteries of the financial crisis is how mortgage investments that turned out to be so bad earned credit ratings that made them look so good. One answer is that Wall Street was given access to the formulas behind those magic ratings — and hired away some of the very people who had devised them.

In essence, banks started with the answers and worked backward, reverse-engineering top-flight ratings for investments that were, in some cases, riskier than ratings suggested, according to former agency employees . . .

But while the agencies have come under fire before, the extent to which they collaborated with Wall Street banks has drawn less notice. The rating agencies made public computer models that were used to devise ratings to make the process less secretive. That way, banks and others issuing bonds — companies and states, for instance — wouldn’t be surprised by a weak rating that could make it harder to sell the bonds or that would require them to offer a higher interest rate. But by routinely sharing their models, the agencies in effect gave bankers the tools to tinker with their complicated mortgage deals until the models produced the desired ratings.”

This is something that only a few people have long suspected: That the Agencies were complicit — active participants — in the gaming of their own ratings.

Its one thing to poach an employee to figure out some of the secret to how sausages are made; But from a business perspective, I didn’t imagine the Agencies themselves were so foolish as to allow their secret sauce to become widely known amongst underwriters.


Rating Agency Data Aided Wall Street in Mortgage Deals
NYT April 23, 2010   

Category: Analysts, Credit

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

24 Responses to “Reverse Engineering AAA Ratings”

  1. Hans Robert says:

    Well for some securities they don’t send the models, just give out tables that map model expected loss to a rating.

  2. Blurtman says:

    This is not news to anyone with access to Google. I retrieved a lot of information that I did not exactly apprehend when searching Moody’s and Standard & Poor’s way back when, but even I was able to see that they had posted their models on the internet.

    I could not believe that the raters would be telling people essentially how to structure their securities so they would pass their rating scheme.

    So if even a naive waif like myself had known this, where the fook are the cops???

    Lastly, you could not write better satire than Christopher Cox’s offical SEC bio: http://www.sec.gov/about/commissioner/cox.htm

    Cox for President! (Of Kyrgystan.)

  3. Myr says:

    The CDO desk next to me where I used to work called the process “credit ratings arbitrage.” Part of the juice in the trade came from being able to take an investment grade RATED security that was trading like junk and stick it into the underlying pool to be securitized. Moody’s and S+P would then use their own credit rating rather than the market price to determine the likelihood of default.

  4. gridlocked says:

    Only a few people suspected this?

    Wow I’ve thought this was obvious since 2008 to anyone paying attention.

  5. advsys says:

    The complicity comes from the fact that they did nothing once they knew that the banks had their models. It is that they did nothing after that point. If they were truly independent they would have taken steps to prevent that information being useful to the banks.

    Google gets attacked in this manner all the time. Some smart group of guys find ways to work around googles algorithms and get a higher placement within the google results page. Google has a large team that is always and with great energy figuring out when they have been compromised and thwarting those efforts. No on ever gets to keep their advantage for long. That is how it should have been in banking!

  6. Its_Science says:

    And to think that BR had trouble publishing his book over calling the Rating Agencies “pimps and whores”

  7. Mannwich says:

    This is fraud. Plain and simple fraud. OK, but what is being done about it? The model still hasn’t changed. These ratings agencies are still in business, how? What does it take to get criminally charged with a white collar crime in this country? Is nothing a crime anymore?

  8. ab initio says:

    What should be clear is that the SEC led ratings agency monopoly should end. The system needs to revert to the old days when investors paid an agency to review a securities offering and these agencies sink or swim on the basis of the success of their reviews.

  9. TDM says:

    Were the formulas made available to the buyers?

    The problem with the ratings is that they became defacto capital regualtions. Buyers had an incentive to purchase bonds with higher ratings to have lower capital requirements. When (enough) buyers and sellers both want everything rated AAA, everyone gets what they want.

  10. bsneath says:

    My experience with financial risk models (although not rating agency models) is:

    1) There oftentimes is a professionally accepted range that may be assigned to many of the input risk variables.

    2) An inherent risk with these models is that the mathematical relationships between variables oftentimes will create unintended “compounding effects” that magnify output errors.

    3) These “compounding effects” are mitigated however when professional assignments of risk for some variables are greater and others are less then actual risk characteristics. (A situation that would normally be expected to occur with in acceptable bell curve standard deviations when the models are prepared by experienced, objective professionals.)

    4) However if someone wishes to manipulate the model, they can assign low values – from within the professionally accepted range – to each of the input risk variables. The model then yields their desired results and yet it is performed consistent with accepted professional standards.

    This was done many years ago on a public/private partnership venture that I was involved in. The corporation’s model yielded results that our financial consultants believed were entirely inappropriate. They informed us that the corporation’s model assigned very low risk values from within the professionally accepted ranges to each of their input variables. Thus they were able to certify their work was performed in accordance with professional standards.

    I have no idea if this happened with rating agency models or if it is even applicable, but it might explain one manner in how banks were able to “game” these models to secure triple A ratings particularly with access to the “cheat codes” and how the rating agencies were able to justify (rationalize?) that their work was conducted to professional standards while securing lavish fees.

    On a related matter, we paid rating agencies $25,000 to $35,000 to rate bond issues of $100 to $300 million. I understand rating agencies received upwards of $1.5 million to rate CDOs. Certainly this is comparing apples to oranges, but it makes one wonder, were the CDO fees demanded by the agencies or offered by the banks? With at least 3 rating agencies available to rate CDOs (Moody’s, S&P, Fitch), there should have been ample competition to allow banks to keep CDO rating costs low. That is of course unless that was not their primary objective.

  11. The Curmudgeon says:

    This is news? Of course they reverse-engineered the bonds to get the ratings. It’s just like the reverse engineering a tax/financial consultant does to, e.g., minimize a tax burden for an individual or entity. There’s really nothing unusual or surprising here. The surprising part is not that the bonds were reverse-engineered and the system gamed (see taxes, above); the surprising part is how easily the ratings agencies rolled over for the bond underwriters. They knew full well the bonds were shit, but preferred to, in effect, delude themselves behind the visage of an outwardly-appearing rigorous analysis. And if you wish to understand why, just follow the money flow–from the underwriters to the ratings agencies. It was a conflict of interest, plain and simple, that was allowed and even encouraged to flourish with the imprimateur of legitimacy stamped upon the transaction by the government (by the government’s endorsement and use of the ratings of the agencies).

    A man will readily suspend disbelief, or even believe in outright lies when he knows them as such, when his sustenance depends upon it.

  12. Tarkus says:

    “The Curmudgeon Says:

    And if you wish to understand why, just follow the money flow–from the underwriters to the ratings agencies. ”

    I don’t understand. Do you mean I can’t pay-off the meat inspector to stamp my dog-food sausages as prime-cut? If I do, can I just pay a little fine and admit no wrongdoing, then keep selling my dog-food sausages as Best and Brightest Sausages? I don’t understand.

  13. Marc P says:

    I’ve always have been curious about how much money a creator of the security pays to have it rated. Anyone know?

    This situation burns me up. The bond ratings companies claim they have no duties to the public or the buyer. They claim that the buyers cannot sue them because there was no duty.

    As long as the regulators allow this state of affairs, then we will have these crises.

    Is this any different than in the dot com era, when the supposedly independent analysts gave positive ratings to the IPO securities the banks were selling?

    Is this any different than in the S&L era, when the supposedly independent appraisers gave positive ratings to the houses that were selling?

    Wall Street has learned well. They’ve learned that to avoid a fraud charge all you do is put a supposedly independent intermediary between you and the buyer. The buyer loses and sues. The seller defends by saying that it wasn’t the one representing that the securities were good; the “independent” analyst defends by saying that it owes no legal duties to the buyer.

    I expect this to be the central theme of the GS defense, along with claiming the the buyers were sophisticated and should have read the prospectus.

    Sad. The demise of capitalism. Some people think capitalism means unfettered markets. That’s crap. Capitalism is predictable markets. The great success of U.S. economy has been predictable markets and transactions. If I buy beef I know it’s been inspected. If I didn’t, then the grocery business would be a very different business, with slower transactions and higher transaction costs. Whether beef, Rule 10b-5 or the UCC, America has thrived on predictable and easy transactions. If GS wins or gets a slap on the wrist, it will be another nail in the coffin of U.S. capitalism.

  14. “If I buy beef I know it’s been inspected. If I didn’t…”–Marc P, above


    for starters..
    and/or: http://www.the-inspector.com/main.htm

    LSS: don’t be so sure..
    The Curmudgeon Says: April 24th, 2010 at 2:53 pm


    no kidding. though, do you think We’d get that Story from STORY and MORGENSON?
    somehow, I don’t think it’d get past the “All the News, That’s Fit to Print”-filter..
    “The majority of people believe in incredible things which are absolutely false. The majority of people daily act in a manner prejudicial to their general well-being.”
    Ashley Montagu, American anthropologist

  15. Daffyorbugs says:

    Here’s a good article on the subject from David Merkel


  16. victorberry says:

    Maybe Lloyd Blankfein can explain to Congress next Tuesday how the Goldman-Sachs proprietary definition for fiduciary responsibility came to include the terms “gaming the system” and “self-enrichment.”

  17. [...] The ratings agencies let Wall Street know their “secret sauce.”  (Big Picture) [...]

  18. Moss says:

    The most amazing stat of these securities was how many, the sheer notional value, that had A ratings. It was so out of whack with reality when compared to the number of corporate bonds which had similar ratings. How could it be that only a few corporate credits were triple A yet the majority of these securities got investment grade ratings.

    We all know why now… so they could find buyers for the fraudulently rated securities. If they could not get the appropriate rating they would not be able to sell to those institution who could only invest in investment grade. Were the ratings correct the ‘market’ demand for this crap would have been significantly less and the supply would have shrunk. The demand was in effect fabricated by the rating fraud.

  19. adamthehutt says:

    In computer science, it’s generally considered naive and counterproductive to pursue “security through obscurity”. Encryption algorithms and the like are only taken seriously if they’re fully public and transparent, since that’s the only way they can be vetted by experts and thoroughly demonstrated not to have holes, etc.

    I know a lot more about encryption than I do securities ratings, but is there no way to take a similar approach? Would it not be possible to create a sufficiently robust, “hack-proof” rating formula that it was only made stronger through full public disclosure? Just curious…

  20. gunlaw says:

    The Curmudgeon has it right: it’s about conflict of interest. A broker who designs a CDO and sells it long and short to his clients has a Day 1 and permanent conflict of interest. That is 10b-5 “Material” on its own. The same goes for a rater who is employed by the broker. What is remarkable is that the broker’s and rater’s legal advisors didn’t point it out when CDOs were first invented, if you can call them inventions.

  21. DeDude says:

    And that would all have been fine provided that the rating agencies were forced to have some skin in the game. I still think we should drop ratings and instead let them make a living by selling credit default insurance. The rating of a security should be the price of insuring (to maturity) the security. And whatever that rating is the rating agency should be forced to sell insurance for to anybody wanting it. The only people who should be allowed to hold insurance should be the ones who own the security, and the insurance should be transferable with the sale of the security.

  22. ewmayer says:

    Uh, the “secret formula” used to generate the ratings was leaked several years ago … here it is pseudocode form:

    If (bond_issue == “paying customer”), then (bond_rating = “AAA”) Endif

  23. FrancoisT says:

    Prosecute, convict, jail!