A Formula for Gaming the Ratings Agencies

It looks like it wasn't too hard to game the formula the ratings agencies used to evaluate bonds:

Rating Agency Data Aided Wall Street in Mortgage Deals, by Gretchen Morgenson and Louise Story, NY 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...

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.” ...

But for Goldman and other banks, a road map to the right ratings wasn’t enough. Analysts from the agencies were hired to help construct the deals. ... For example, a top concern of investors was that mortgage deals be underpinned by a variety of loans. Few wanted investments backed by loans from only one part of the country or handled by one mortgage servicer.

But some bankers would simply list a different servicer, even though the bonds were serviced by the same institution, and thus produce a better rating... Others relabeled parts of collateralized debt obligations in two ways so they would not be recognized by the computer models as being the same...

Banks were also able to get more favorable ratings by adding a small amount of commercial real estate loans to a mix of home loans, thus making the entire pool appear safer.

Sometimes agency employees caught and corrected such entries. Checking them all was difficult, however. “If you dug into it, if you had the time, you would see errors that magically favored the banker,” said one former ratings executive... “If they had the time, they would fix it, but we were so overwhelmed.”

There are two problems that need to be fixed. The first is the incentive that ratings agencies have to give high ratings, and the second is the gaming of the ratings formula described above

The first problem, the incentive to provide high ratings, arises because the firm paying to have the financial asset evaluated also picks the ratings agency. A reputation as a tough rater is not good for future business, so there is an incentive for the agency to provide the rating the company is looking for. There are a variety of ways to fix this, e.g. a third party selects the particular agency that will do the rating (so that low rating does not affect the probability of being selected in the future), but so far Congress has not proposed the needed reform.

The second problem, the gaming of the ratings formula, is also helped by having a third party select the ratings agency. When the company gets to select the ratings agency itself, it can craft a strategy to precisely take advantage of the formula used by that agency. But if each company has different strengths and weaknesses, and any company could be selected by the third party, it won't be as easy to know which particular game to play. If the wrong agency is chosen, the result could be a lower than expected rating. This doesn't stop all potential gaming, for example a common flaw across all ratings agencies can still be exploited, but it does make it generally harder to game the system.

I don't think ratings agencies were the root cause of the financial crisis, but they did make it much, much worse by allowing so many highly rated but actually toxic assets onto the balance sheets of financial institutions. There is a need to fix the ratings agency problem, but as noted above there has been no action from Congress on this issue. Perhaps the recent attention to the role the ratings agencies played in the crisis will change that, but I'm certainly not counting on it.