Friday, November 7, 2008
OK, Back To Bond Business
The idea that bond ratings are like weights and measures in commerce is a bit too simple because unlike weights and measures that remain constant, or at least on planet earth they remain constant, bond ratings can and should change as their coverage changes.
Let me explain. Bond ratings are more than mere opinions as the heads of the three large rating agencies, spell that companies, gave testimony before a House committee just a few weeks ago. To claim that the AAA rated bond rating is a mere opinion is plain bullshit. Bond ratings are a significant piece of information that goes into a buyer’s decision to purchase a new bond issue whether it be a mortgage-backed bond or the municipal bond of a local school district. Ratings are suppose to mean something. What do ratings mean?
Well, now we are getting to the heart of the matter, “what do bond ratings mean?” Simple put, a bond rating reflects an issuer’s ability and willingness to pay principal and interest in a timely manner. Most bonds, when I was in the bond business, were set up to pay interest twice a year. So, if a $1,000.00 bond had a 6% coupon rate (also known as the interest rate), the bond would pay the bond holder $30.00 twice a year. If for example the bond had a maturity date of June 1st, interest would be paid to the bondholder on June 1st and six months later on December 1st. This process would continue until that bond matured and then a final interest payment along with the principal amount of the bond would be returned to the investor.
In the real world, conditions change as we can see from recent economic events. Bond ratings reflect the ability of the bond issuer to make the semiannual interest payments. The issuer's size and outstanding debt and previous debt obligations are included in the process of determining the quality of the bond rating given to any new debt issued by the bond issuer. Coverage of the interest expense is part of the formula that rating agencies use to determine the proper bond rating. But, coverage, a ratio, like two times or 2.5 times can change with economic conditions. In the case of the asset-backed bond, such as a mortgage bond, the value of the asset behind the debt can change. If the value of the properties that are behind the mortgage bond go down in value, the value of the mortgage bond, even if interest rates do not change, will most likely decline. Now if the mortgage is a fraud from the get go, we have a problem. In fact, if this is a pattern of behavior, we have a big problem.
There was a huge appetite for asset-backed bonds among the institutional investors in the United States and around the world. This appetite for asset-backed bonds, in my opinion, lead to the meltdown. Let me explain. With billions of dollars to be invested, and interest rates staying relatively low, institutional money managers are under pressure to out perform other money managers or lose their accounts. The money managing a few hundred million or a few billion dollars at the institutional level is big business. Portfolio managers will “reach” for yield in order to raise the total return performance of their portfolio. Asset-backed bonds gave portfolio managers that extra yield that they needed if they hoped to out perform their competition. This was the sucking sound that pulled more and more mortgage-backed bonds into the market. With demand for mortgage and other asset-backed bonds so great, the large investment banking firms that did the underwriting of these issues put pressure on the ratings agencies to come through with favorable bond ratings regardless of the fact that many of these new bond issues should have never received a rating in the first place.
Now, perhaps you can understand why I am calling on the Congress to take away the responsibility of bond ratings from the private for profit companies that have been doing this job for too many years and place it within the Federal government. It may not be a total answer, but in my opinion, the profit motive in bond ratings must be removed if we are to rebuild confidence in the markets in a timely fashion.