Evading Reality - 4

Based on a Joshua Rosner NYT op-ed piece and some other stories in the NYT:

By law, banks, insurance companies and pension managers can purchase only high quality bonds. The quality rating of such bonds is issued by Standard & Poor's, Moody's Investor Service and Fitch Ratings.

Mortgage lenders make loans to home buyers and aggregate these loans and sell bonds ("mortgage backed securities") in the financial markets. The ratings agencies gave high ratings to subprime-mortgage backed securities (subprime means high-risk loans made to home buyers who previously would not have qualified for them), and only belatedly reissued ratings **after** the subprime crisis was upon us. The crisis is caused by the sort of obvious fact that people who on the average were expected not to be able to make the interest payments on their loans are turning out as expected not to be able to make payments on their loans and so are defaulting.

If so much institutional money was not available because of the high ratings given to such bonds, then subprime lending would have been limited. But...

Rosner:

...the ratings agencies are far from passive arbitrators in the markets. In structured finance, the rating agency can be an active part of the construction of a deal. In fact, the original models used to rate collateralized debt obligations were created in close cooperation with the investment banks that designed the securities.

Fitch, Moody's and S.&P. actively advise issuers of these securities on how to achieve their desired ratings. They appear to be helping investment banks, hedge funds and fund companies, all of which have a fiduciary obligation to investors, to develop the worst possible product that would still achieve a certain rating.

Only slightly more than a handful of American non-financial corporations get the highest AAA rating, but almost 90 percent of collateralized debt obligations that receive a rating are bestowed such a title. The willingness of Fitch, Moody's and S.&P. to rate as investment grade many assets that are apparently not has made structured securities ratings their fastest-growing line of business. Are we to believe that these securities are as safe as those of our most honored corporations?

Of course, simply the fact that someone has rated something as high-grade does not compel a pension fund manager to buy it. The problem is that most institutions do not have the expertise to be able to independently evaluate these financial instruments.

--- This morning's news is that both the European Union and the US Congress will be looking at the performance and conflicts of interest of the ratings agencies.

PS: Cartoon