Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Structured by cows or by foxes?

An Instant Message Dialog in which a rating agency employee claimed that “it could be structured by cows and we would rate it ” has been repeatedly quoted as evidence of the failures of the rating agencies in rating complex structured products in the build up to the global financial crisis. It also finds mention in a ruling earlier this month by the New York District Court allowing a case against a rating agency to go to trial (h/t FT Alphaville).

I find this puzzling because the least dangerous structured products to rate are those designed by incompetent simpletons. These would more likely correspond to the random samples to which statistical modelling is easiest to apply. The hardest instruments to rate are those put together by cunning foxes rather than by dumb cows. The cunning foxes are likely to design instruments with an intent to game the rating agency models. Model errors that may be harmless in the context of randomly designed pools could be disastrous when the pool is designed to include the worst securities that could scrape through the rating agency’s models.

That the rating agency employees did not realize this is strange. However, the fact that after years of being exposed to Abacus and Magnetar, many commentators do not seem to realize this is even more puzzling.


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