Monday, October 20, 2008

At The Cellular Level: Bonds And Cancer

For the large institutional buyer of investment securities, credit worthiness is, in my opinion, the most important factor in the decision to purchase a fixed-income security for a portfolio.

There are several different treatments for fighting cancer. One of those treatments or strategies, that is still being worked on, is to manipulate certain proteins so the cancer cells will not take in nourishment from the blood supply of the body they are in. Work on this particular kind of research has been done at The Ohio State University. (See, they do things besides play football at Ohio State.) At the cellular level, without hurting the patient, it some day will be possible to stop the growth of a tumor right in its tracks. For all those cancers that are inoperable, this strategy and treatment will someday save millions of lives.

Now, let us jump back to the field of finance and fixed-income investments and portfolios. Remember, I said in my opinion credit worthiness is the most important factor in the decision to purchase a fixed-income security. Well, let me change that slightly. Credit worthiness and the credit rating assigned to an asset-backed bond that is made up of several mortgages, car loans or manufactured housing loans is of critical importance. If a portfolio manager that is managing a portfolio of asset-backed bonds, finds out that the AAA rated bonds that have been purchased for the portfolio are not really of AAA quality, the portfolio manager has what amounts to as a “cancerous tumor” instead of a AAA portfolio.

When the market makers at the large securities firms realize that there may be a problem with the creditworthiness of asset-backed bonds, trading in those securities comes to a halt. Who wants to buy asset-backed bonds for their trading position if they do not know what the value of the properties behind the mortgages are?

The way I see the growth in the volume of asset-backed bonds and the growth of the asset-backed bond market is much the way I see a cancer permitted to grow. The AAA credit rating that was given to these asset-backed bonds gave the portfolio managers in this country and around the world, the signal that these securities were of the highest credit worthiness. Without the AAA rating, the cancer that these asset-backed bonds carried would have never invaded all those institutional portfolios. Some portfolio managers, hungry for yield, may have bought un-rated asset-backed bonds, but few, in my opinion, would have placed a significant percentage of their fixed-income portfolios in such questionable credits. Without the AAA credit rating, the mortgage-backed bond market would have never permitted the housing bubble, spell cancer, to grow. Without the purchasing power of the institutional portfolios, public and private pension funds, the housing bubble would have been stopped in its tracks.

Now, if what I wrote today does not make any sense to you, please do not feel bad. My mind works differently that most peoples. First, I am left-handed and secondly, I was raised in a different environment than most. Crazy ideas were pretty much the norm in the house where I grew up. But, that said, I do know something about bonds and the bond markets and what a meltdown is. Unless the rating of fixed-income assets, especially those asset-backed bonds, are moved to a governmental agency instead of a private for profit company, the pain and suffering and financial loss of this meltdown will be seen again.

Stay tuned.


winslow said...

After all the shenanigans we have seen, I have to agree that the government needs to directly regulate the rating of bonds.
Also, the government should have caught these bond-rating companies during the process. I hope the joint meeting of nations can produce new regulations that work. Why do I get the feeling that Bush will drag his feet? Can't wait to get him out of office.

moneythoughts said...

The investor, whether a large institutional buyer or a single individual investor, deserves to have fixed income securities, like asset-backed bonds, rated properly. No cutting corners because the volume of new issues is going through the roof!!! The analysis should go in before the rating goes on. If the FBI wants to look at the bad guys in this latest meltdown, perhaps they should turn their sights on three rating companies.