Moody’s, Rating Models, and CDOs

On page 140, we write this:

“In 2004 and 2005, both Moody’s and Standard & Poor’s modified their rating models in ways that made it easier to give higher ratings to CDOs, helping extend the structured finance boom.”

The source for that sentence is a Bloomberg article entitled “‘Race to Bottom’ at Moody’s, S & P Secured Subprime’s Boom, Bust.” The article begins this way:

“In August 2004, Moody’s Corp. unveiled a new credit-rating model that Wall Street banks used to sow the seeds of their own demise. The formula allowed securities firms to sell more top-rated, subprime mortgage-backed bonds than ever before.”

Further down, the article focuses on a rating model introduced in August 2004 by Gary Witt, which shifted from the older “binomial expansion technique” (BET) for modeling diversity in a portfolio of assets to a “correlated binomial” technique, and quotes other sources saying that the effect of the new model was to boost the ratings of CDOs.

Gary Witt is now a professor of statistics and finance at Temple University, and he sent me the following information by email:

  • The new model would have increased the projected losses for AAA CDOs relative to the BET approach, which might have implied lower ratings, but not higher ones.
  • The model introduced in August 2004 was not actually adopted by Moody’s for rating CDOs based on RMBS (residential mortgage-backed securities) or ABS (asset-backed securities, a category that often included subprime mortgage-backed securities).
  • Instead, in 2005 Moody’s adopted the normal copula approach (favored by the investment banks).

So, if Witt is correct (and I have no reason to think he isn’t), the underlying article we used was wrong. There is still the question of what impact the 2005 change to the normal copula approach had. (Felix Salmon has previously criticized this type of model.)

Witt’s opinion is that the new model on balance did not make it easier to give higher ratings for CDOs. The BET had assumptions about independence that were clearly inaccurate by 2005, and the new model was an improvement. Still, Witt acknowledges that it’s not an open-and-shut case, in part because the models take different approaches to measuring correlation. For one thing, introducing a new model induces investment banks to behave strategically and game the new model, so it doesn’t make sense to simply take a given CDO and rate it using the two models; in practice, the banks will create different CDOs that are influenced by the properties of the two models.

So on balance, the sentence at the beginning of this post isn’t supported by the source we cited (at least when it comes to Moody’s).


The Council on Foreign Relations

I was on Wisconsin Public Radio this morning and got a call from a listener suggesting that the problem was that all the key members of the administration are also members of the Council on Foreign Relations. I said that I didn’t think that Summers and Geithner were official members of the CFR (although the general issue that the members of the administration are part of the same Washington establishment in general is a problem). Afterward I looked it up and both of them have had official CFR affiliations in the past.

I still don’t think the CFR is calling the shots, but I was wrong on the facts. Sorry.


I forgot to mention that four of the more important charts from 13 Bankers are in last week’s post on The Huffington Post.

And, Tyler Cowen’s discussion of the book is also up at The Huffington Post. I think we’ll probably wait for a couple of more posts and then write a synthesized response.

Interview with Christopher Lydon

I did a long interview with Christopher Lydon for Radio Open Source. I’m especially proud of this because Lydon was one of the people who pioneered podcasting, although he insists that Dave Winer did most of the work. At my company I used to do a very low-tech podcast, basically using an external microphone plugged into my iPod.

As a side benefit, Lydon also gave me a copy of The Big Short inscribed to me by Michael Lewis, and I’m just happy that Michael Lewis knows who I am.

More Media Stuff

If you want to see a full-length presentation, there are videos available of Simon’s appearance at MIT and the World Affairs Council of Washington last week.

Also, I’ll be talking to Larry Doyle of Sense on Cents on Sunday evening at 8 Eastern.

13 Bankers Is Arianna Huffington’s Book Club Pick!

Huffington’s announcement and review are here. Huffington, of course, is widely known as a leader of the progressive wing of the Democratic Party. But one main point of her review is that our book has real bipartisan appeal:

“You know a book is onto something when, even in these politically polarized times, and dealing with a hot button issue like financial reform, it features side-by-side praise from both Jim Bunning and Alan Grayson. Yes, that Jim Bunning.”

The great thing about the selection is that the Huffington Post will host a month-long discussion of the book, including external bloggers and commentators, some of whom no doubt will disagree with some or all of the book. Our first post in the series will be out tomorrow.

Review in Fortune

Katie Benner has a review of our book in Fortune complete with a huge picture of me (the same picture everyone has). It starts not too promisingly: “Of all the books about the financial crisis, 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown, is the least sexy.” (Hey! I always wanted to write sexy books.) But Benner means that as a compliment: “This staid looking text holds an explosive idea: Wall Street has hijacked our government. And without a total overhaul, taxpayers will endlessly foot the bill for its sins.”

Benner focuses on one of the central ideas of the book:

“While politicians debate minutia, Johnson and Kwak say they’re not addressing the real problem. Until the banking sector is a much smaller segment of our economy, banks will always have too much power. And as long as basic economic functions like mortgages and car loans depend on subsidizing their risky activities, we’ll keep bailing them out.”

This, we think, is the central problem. Breaking up big banks is our recommended solution, but that’s open to debate. But our main goal is to get people to agree on what the problem is.