Saturday, April 24, 2010

The Catch-22 of Credit Rating Model Transparency

As reported in the New York Times...

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...

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.

“There’s a bit of a Catch-22 here, to be fair to the ratings agencies,” said Dan Rosen, a member of Fitch’s academic advisory board and the chief of R2 Financial Technologies in Toronto. “They have to explain how they do things, but that sometimes allowed people to game it.” ...David Weinfurter, a spokesman for Fitch, said via e-mail that rating agencies had once been criticized as opaque, and that Fitch responded by making its models public...

Read the rest of the article at www.nytimes.com/2010/04/24/business/24rating.html

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