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Ratings agencies have been criticized for inadequately determining risk in the massive collection of debt securities created in the credit bubble. An excellent example of credit rating alchemy is found in an NBER (National Bureau of Economic Research) study by Harvard professor and NBER member Efraim Benmelech. The following graph is from that report.

One might argue that it is possible to take a large number of riskier things together and have the assemblage bear less risk than any individual part. But turning 100% junk into AAA? That does seem a bridge too far.

The CDO (collateralized debt obligation) tranching process is one in which the issuer designates (and rating agencies certify) a hierarchy of credit quality with some tranches deemed to be of lower credit quality. Defaults are realized first in the lowest rated tranches. The assertion of the issuer and rater are that the risk of default of the highest tranche is comparable to U.S. Treasuries because defaults will be assumed by the lower tranches before the AAA tranche is affected.

In the above illustration 70% of the CDOs were rated "risk free" (AAA). Up to 30% of the underlying securities could default without imposing any loss on the top tranche. Or so the issuers and rating agencies said.

The entire alchemy rests on some basic assumptions. In order for credit enhancement to occur the individual risks in a CDO must be independent from each other. If the risks are closely correlated, then building a CDO simply projects the same risk as exists for each component. In the example illustrated 89% of the CDOs were rated BB and higher, while 99% of the collateral was rated BB- and lower. That is major enhancement.

The assumption of independent risks was flawed. The first reason was failure to fully recognize systemic risk. It simply was not considered that a collapse of 30% or more in home prices could occur. It was simply not considered that money center banks could become insolvent as a group.

The second flaw came from pryamiding debt. Many CDOs were themsleves composed of collateral that were CDOs. Benmelech writes:

While initially ABS CDOs were diversified and collateralized by assets from a variety of sectors, they became more concentrated over time.

Concentration in narrow sectors increases business risk.

The pyramiding of debt also enhances risk. Consider that the lower tranches of the CDO illustration. Now repackage them into a new CDO. The process could now elevate 70% of the former junk (the lower 30% of the original CDO) into AAA. The second level CDO adds 21% of the original collateral to the AAA pool. That brings the total up to 91% AAA. After three levels in this example with 30% below AAA remaining after each level of collaterization, 97% of the original junk has been transformed into AAA. Alchemy indeed!

Note: The preceding example is illustrative of concept, not a specific process.

It is not a surprise that a financial collapse occurred. It is a surprise that the causes are so simple. It is a surprise that those responsible for this mismanagement of the basic concepts of debt and collateral have been left in control of the system and can continue to practice their alchemy.

Disclosure: No stocks mentioned.

Source: It's the Collateral, Stupid