Tuesday, March 24, 2009

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Credit Ratings and Probability of Default

As i was researching for this article, I came across a startling fact about serious involvement of rating agencies and the collapse of our financial system. IT is called as credit rating or credit worthiness of a company, for example moodys has a rating schema as follows Long-term Debt Ratings (maturities of one year or greater)

Investment Grade
Aaa – highest rating, representing minimum credit risk
Aa1, Aa2, Aa3 – high-grade
A1, A2, A3 – upper-medium grade
Baa1, Baa2, Baa3 – medium grade
Speculative Grade
Ba1, Ba2, Ba3 – speculative elements
B1, B2, B3 – subject to high credit risk
Caa1, Caa2, Caa3 – bonds of poor standing
Ca – highly speculative, or near default
C – lowest rating, bonds typically in default, little prospect for
recovery of principal or interest

The credit risk analyst at AIG and other insurance companies who insured these CDO's did it without capital backing and secondly it gave a clean chit to the banks that since the securities were insured "risk" was reduced on their balance sheet. A quant engineer or a Credit Risk Analyst predicts the rate of default or probability of default on the basis of the ratings given by the credit rating agencies like Moody. From 1995-2004 there has been 0% default rates for AAA rating companies or securities, however when AIG insured the bank CDO these mortgage back scurities immediately became AAA rating the rating given to AIG itself, and we know the rest of the story.

Although if based on priori information its difficult to convert the ratings to probabilities of default you can do it using modelling techniques so as to assign AAA rating some kind of default probability and not 0. There are some curve fitting techniques which can model it perfectly, but needs more perfection. I will try to investigate these modelling/curve fitting/regression etc to find out that will assign a decent PD to the rating.

UPDATE : Goldman Sachs is planning to return the govt money

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