The Case for Machine Learning

in Credit Ratings

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Machine learning depends on good data, not big
data, and surely not on big swinging data.
Machine learning in finance = the application of statistical techniques to the analysis of financial data.
A variety of analytical methods are used but the usual suspects-regression (linear and non-
linear), discriminant analysis (SVM), neural networks, etc. are the workhorse methods.
Data for analysis are generated in both primary (underwriting and performance) and secondary
(trading) markets.
Sometimes, the datasets are sufficiently large to speak of big data applications although per se,
the expression big data is a meaningless slogan.

Credit ratings are typically a byproduct of human judgment. But, data intensity makes structured credit ratings
particularly well-suited to machine learning, as the flowchart below makes clear:

Structured Finance
Rating Scale
Letter Grade -IRR
Tranche Aaa 0.06
Aa1 0.67
Outcomes
Aa2 1.3
Aa3 2.7
A1 5.2
rA(n) DIRRA ,tA Yield Curve
YA A2 8.9
Waterfall
rB(n) Editor DIRRB ,tB Model YB A3 13
Baa1 19
Target Baa2 27
Deal Baa3 46
rA(n+1) = rA(n) + A A = YA- rA(n) Ba1 72
Ba2 106
rB(n+1) = rB(n) + B B = YB- rB(n) Ba3 143
B1 183
B2 231
= Relaxation Factor (over or under) B3 311

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 uncertainty with respect to ultimate principal losses at origination does not
change over time,

True structured ratings need data feedback.

ABSTRAKPhilosophy

false. The failure of ratings to change in response to new data spells danger
when the risk exceeds original forecasts, as happened in the Global
Financial Crisis. As the figure above illustrates, by the time the need for
Actual losses higher than expected.
downgrade is obvious, the damage has already been done.
Someone takes the hit.

even though there is updated pool performance information every month.

This assumption is not even wholly true for corporate credit risk. For
securities backed by an amortizing pool it is wastefully and dangerously
This can play out
!
one of two ways in
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the after-market.
Assumed loss curve for initial rating.
Credit rating agency ratings on structured implicitly assumeerroneously, it
turns outthat structured credit quality is essentially static. This meansas
Actual losses within range.
the above figure illustratesthat the degree of pool performance All clear.
uncertainty with respect to ultimate principal losses at origination does not
change over time,
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Well-structured transactions follow the opposite pattern. Expected losses
 Loss curve is updated via Markov-Matrix
modulation.

Four parameters of a non-stationary set of Markov delinquency-transition matrices:

cumulative defaults
cumulative prepayments
30-day delinquencies
60-day delinquencies
updated with fresh servicer data as they become available, using multi-dimensional NR optimization.
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 Security ratings are refreshed, so fair pricing keeps
pace with risk and redundant capital can be released.

Positive Example: Ford Credit Owner Trust 2000-A

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 A RMBS deal: Countrywide Home Loans
2005-BC5

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 Extending the Paradigm to ST Claims
Rating & Valuation in Real-Time:

lay
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Am
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 Thank you all!

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