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Bonds, lame bonds

Below is a dispatch on bond rating agencies from my former CCPA colleague, Stuart Murray:

Here is some more grist for the blog.  Bloomberg just published a very interesting and informative article on the role of the bond rating agencies in the current meltdown.

The pitchforks are out for Moody’s and S&P, as they gave glowing ratings for the Collateralized Debt Obligations that paid for the subprime mortgages.  People have mostly ignored the role of the bond raters, which is a big mistake.  In my opinion, if the bonds that funded the subprime mortgages were correctly rated as “equivalent to toilet paper” then investors would not have bought them, and the loans wouldn’t have been made.  Or at least the interest rates would have been so high that it would have eliminated the profit margin, which would have the same effect.

Instead, the bonds were repackaged in a way that is indecipherable to even those who have economics degrees, and were then rated as “a pretty good investment.”  Apparently, the bond raters were in a conflict-of-interest over their consulting fees, comparable to the role of auditors at Enron.  So now there is a nasty lawsuit.

Also of interest in this article is the fact that you get a better reading of the value of a bond by “tracking the prices of credit-default swaps.”  Apparently, the bonds for troubled banks had investment-grade ratings right up to the week before their collapse, but the credit-default swaps had a far more accurate downward spiral in the months leading up to the collapse.  Who knew?  Apparently, some guy who started switching his investments to gold coins as he saw the spiral on his computer screen.

On the topic of “you’ve got to be kidding” please note the following:  “S&P included a standard disclaimer with Lehman’s ratings: ‘Any user of the information contained herein should not rely on any credit rating or other opinion contained herein in making any investment decision.’”  So the bond raters are building their entire business around helping investors make decisions around what bonds to buy, but throwing in a footnote that “hey, if you use our information to make investment decisions, you are the moron, but thanks we’ll take the cash.  Okay thanks bye.”  All that’s missing is the top-hat, the twisting of the waxed handlebar moustache, and the evil cackling as they walk away with stuffed brown canvas bags with dollar signs on the side of them.

It is fascinating to watch the Wall Street types discuss what to replace the bond raters with.  Wall Street has quickly ruled out a government-owned agency, for the standard reasons you would expect:  “I would be strongly opposed to the government taking over the function of credit ratings… I just don’t think it would work at all. The business creativity, the drive, would go straight out of it.”  I think what they’re saying is that the bond raters wouldn’t get paid as much, and as such the type-A blueblood salesmen types would have less control over the economy.

It looks like people are interested in a bond rating co-op that is owned by the people who use the service, which they compared to Consumer Reports, but sounds more to me like Mountain Equipment Co-op.  Which begs the question, how long will it be before finance ministers are terrified by visits from bond raters who wear goatees, hemp shirts and Birkenstocks?  “Oh crap, there’s a 1979 Volvo in the parking lot, we’re screwed!”

Incidentally (i.e. it’s not in this article), I was always baffled by how the bond-raters gave top ratings to P3 bonds that were backed by bond insurance (aka monoline insurance).  From what I understand, the repackaging of the debt was similar to the repackaging of Collateralized Debt Obligations.  Now that the latter are in disrepute, presto! No money for P3s.

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