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.

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Source:

Rating Agency Data Aided Wall Street in Mortgage Deals

GRETCHEN MORGENSON and LOUISE STORY

NYT April 23, 2010

http://www.nytimes.com/2010/04/24/business/24rating.html