How to engineer a financial mess

An article in today's Dallas Morning News explains a little of how subprime loans were incorporated into securities that seemed (on paper) to be safe bets for investors. A big part of the change from risky to safe (safe-looking) was based on getting credit rating agencies -- private firms like Standard and Poor's, Fitch, and Moody's -- to certify the mortgage-backed paper as credit-worthy.

The magic involved what the article's author, Jim Landers, calls "credit engineers" who packaged mortgages of varying credit quality (subprime and safe all mixed together) into collateralized debt obligations and then running the CDOs through computer models designed to grant them a credit rating. Sensible enough. But the computer models the credit engineers used were the same models used by Moody's, et al.

A financial engineer would take thousands of residential mortgages and bundle them together in securities, some of which were called collateralized debt obligations, or CDOs.

The CDOs would include both good and bad credit-risk mortgages from several parts of the country. This spread the risk of default across a range of investors.

The big rating agencies then would run these securities through computers to assess how risky they were. The software was available to the financial engineers. So, before the rating agencies did their analysis, the engineers tested the securities themselves to see what score they were likely to get.

If they didn't like the results, they sometimes took the riskier loans and created a second CDO packaged with other loans, a piece of legerdemain called "CDO-squared." The result was a higher score and a higher credit rating.

The engineers then gave these CDOs to the rating agencies and, voilà, most of the subprime mortgages issued in the last six years earned a AAA rating.

Soooo... If the credit ratings weren't high enough, the engineers commenced to tweak their products and noodle around with a few variables and packaging strategies to adjust the models' evaluations. A Landers points out, this is tantamount to giving a copy of the test to a student to help him study for it. When you allow cheating, the student always gets an A. Or AAA, rather.

But it was all illusion, not magic after all:

In the last 18 months, the credit rating agencies have downgraded three-fourths of those CDOs.

The IMF estimates losses will reach $1.4 trillion from U.S.-originated debt securities.

But wait! There's more! Credit agencies are paid for their work, of course. Guess who pays them? The financial engineers! Conflicts of interest are just about inevitable when a producer pays an evaluator to assess his product so it can be then sold to a third party.