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SEC to Sit on Debt Rating Scam?

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May 29, 2008 – Comments (6)

Ask folks in the know about the entire mortgage backed securities Ponzi scheme, and they'll tell you that a prime cause was the bogus ratings applied to these un-knowable, unfamiliar securities by the ratings agencies. The mirage that fooled investors the world over into buying these things ("triple-A = safe") not only spawned the industry, it made instant riches for banks, ratings agencies, monoline insures, lenders, hedge fund managers and HELOC-dependent U.S. consumers.

Trouble is, the SEC is threatening to take away the punch bowl and make ratings agencies rate this opaque zuppa di stronzo as something other than the same ratings given to munis or corporate bonds. Make perfect sense, right?

Not to the folks who hawk this junk, nor the folks who make money rating it. They're afraid (with good reason) that their precious dog-food triple-A won't be treated the same as real AAA. That would mean pensions, government entities, insurance companies, etc. might not be fooled into buying the drek.

Sounds like a great idea for the world economy, but since it means that the ethics-impaired MBS salesment out there will have to buy shorter yacths, expect them to put up tons of political pressure to make sure it doesn't happen.

---------From the WSJ----------

The staff of the Securities and Exchange Commission is expected to propose rules for credit-ratings companies that would require risk rankings for complex financial instruments -- a move opposed by rating entities, investment banks and others.

The move would distinguish these so-called structured products, which have been blamed for the recent financial crisis, from more-traditional corporate and municipal debt. Ratings companies have been widely blamed for giving overly rosy ratings to mortgage-related securities, and for being slow to downgrade those assessments when the housing market turned.

6 Comments – Post Your Own

#1) On May 29, 2008 at 2:13 PM, IBleedConcrete (33.26) wrote:

The SEC is probably too in bed with Moody's, S&P etc. to punish them for their negligence.  But do you think individual states will have more success?  See Connecticut's investigation into Moody's.

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#2) On May 29, 2008 at 3:46 PM, PokerDonkey (97.09) wrote:

The SEC may have started an inquiry, but that doesn't mean anything will come of it.  http://www.cnbc.com/id/24828441/for/cnbc/

(I hate linking to CNBC, but that's where I first saw the story)

I'd much rather see self-regulation within the industry.  If Moody's or Fitch or anyone else fails to produce an accurate rating, banks and investors shouldn't rely on that rating to assess credit risk.  If FICO scores proved to be worthless, would anyone use them for underwriting?  They might as well pick themselves a random number rather than paying for one.

However, I also think investors should have had a better understanding of the ratings.  The implication may have been that "triple-A = safe", but surely, there's no investment with a 0% chance of default.  And if they're willing to purchase a "safe" AAA rated security, how much safer is it than AA-, or B, or BBB?

Use of these ratings should be used on a relative basis.  For example, if you segment the population equally into 5 risk grades A,B,C,D,E and validate default rates on historical data, you might find default rates of the grades to be 0.25%,1.0%, 3.0%, 9.0%, and 15% with a C grade being the median.  Will an "A" graded loan ALWAYS default at a 0.25% rate?  No.  If an economic downturn caused total default rates to double, you would expect all the rates to roughly double.

Low risk paper is priced with margins so razor-thin, a 25 basis point increase in defaults can make it unprofitable.  Of course, if you have billions in "B" paper priced as "A", and losses increase to 200 bps, you're royally screwed.

I think it's human-nature to equate unlikely with impossible, and expecting the current trend to continue.  Sure, it's unlikely for company like Bear Stearns to go out of business over the weekend, but, evidently, not impossible.  Nor will the price of tech stocks, real estate, or gold, or oil ALWAYS go higher.  People need to take responsibility for their own assumptions and not blindly rely on the government, rating agencies, or banks correctly assessing risks.

Yes, the agencies should be punished.  And it should be by loss of business.  And yes, these banks should be allowed to fail.  Management took on too high of a concentration of debt, whether it was geographic or credit risk or credit type. 

The world is full of idiots; most of them work somewhere.  After they run that business into the ground, they'll work somewhere else.  Caveat emptor.

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#3) On May 29, 2008 at 6:14 PM, TMFBent (99.80) wrote:

I'd much rather see self-regulation within the industry.  If Moody's or Fitch or anyone else fails to produce an accurate rating, banks and investors shouldn't rely on that rating to assess credit risk. 

If there were adequate competition in the field, that might be true, but this was pretty much a protected industry. Moreover, banks and other investors -- or at least the folks nodding their heads at the AAA ratings for those entities -- didn't really have adequate reason to question them, even if they looked bunk. They're often just plain stuck trying to get returns while forced to buy "investment grade," non-risk bonds. That's why the alchemy was so successful. It made equity-like risks look better than that, and the people making the buying decisions could just go "hey, it was rated highly."

If you have a system in which everyone passes the buck back to the rating, better to fix the rating than to assume 1,000s of others will fix their cover-your-a$$ behavior.

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#4) On May 30, 2008 at 12:20 AM, FleaBagger (28.14) wrote:

Seth - You're just being flip about the problems of the super-rich. This isn't about the size of their yachts; they might not be able to afford yachts at all if things go south like that. They might even be forced to work for a living! So try to appreciate the gravity of their situation.

PokerDonkey - It is "unlikely" and yes, seemingly impossible, that we could have a market as free as you say. Even Seth here wants a lot of analysis done for him by gov't regulators. Now just try to imagine how many of the ignorant schlubs like you and me will want the same or more.

Yes, Seth presents a pretty weak argument for government handholding. (That is, he simply says that because it is easier to police a company that should be free to please or fail its customers than it is to let people who are supposed to be working actually fail if they do not do their work, that means it is better.) But think about it: nobody really wants to do all the work it would take to be a prudent investor in a truly free bond (or stock) market, such as the one we had in the 1920's. First time somebody catches wind that it's caveat emptor again, scoundrels will get the idea you've gone soft, and then it's nothing but work, work, work. Life is pain, your highness, and anyone who says differently is selling something. Like Moody's.

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#5) On May 30, 2008 at 4:51 AM, saunafool (98.79) wrote:

Look, I don't see the difference between a municipal bond that says, "we're going to issue bonds for $1 million to build roads, then investors will get their money back with 4% interest over the next 10 years with revenue from taxes,"

or a MBS that says, "we're issuing bonds worth $1 trillion, then investors should get their money back with 4.7% interest over the next 30 years with revenue from thousands of people making their morgage payments, but we're not going to tell you anything about the buyers because we never asked any questions of the buyers, yet our "risk model" says this is AAA prime filet just like the Muni which is backed by future tax revenue.

For an idea of how bogus the "risk models" can be, read the Black Swan.

I'm picking up on a common thread through a lot of these posts--now that all the easy credit has been allowed into the system, how to you return to the time before? Regulate the MBS system to improve accountability and the credit crunch gets worse. Force buyers to provide down payments and documentation of income and housing prices have to fall another 20%. Bail out the homedebtors and you prolong the problem. Do nothing and you leave a system in place where banks, mortgage brokers, ratings agencies, and investment firms are free to shift the risk onto the rest of the world under the banner of AAA prime filet.

Seth, did you make up the "dog food" analogy. It's perfect. 

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#6) On May 30, 2008 at 9:12 AM, TMFBent (99.80) wrote:

Yes, Seth presents a pretty weak argument for government handholding.

I'm not advocating any kind of government hand-holding. I'm saying I think it makes a lot of sense for the SEC to say to bond-raters: Thou shalt have a separate rating system for structured finance.

The reason is simple: Lumping it together with the stuff people are familiar with from decades of experience led to massive problems. It's far different, and giving it a separate rating doesn't necessarily make any judgement on its quality.

Fact is, the rating agencies already differentiated between muni debt and corporate debt. I attended an interesting panel where one presenter showed that the bond raters actually had a different scale for muni bonds than corporate bonds, biased lower. In order to get a better rating, municipalities had to cough up higher fees to the rating agency. If they didn't cough up those fees, they got the lower rating and, of course, had to pay more to borrow.

End result has been that taxpayers have been soaked for billions of extra dollars in fees and borrowing costs -- and here's the kicker -- even though munis have, according to his analysis, been far safer than corporate bonds.

This entire business is ripe for an overhaul.

Rob: I don't know if I made up the dog food analogy, or rather, I'm not sure I didn't just lift it out of someone else's diatribes at some point.

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