The Dominos Of The Financial Industry Started Falling

We all know that several books will be written about the mortgage-bond market meltdown, the financial crisis and finally the economic crisis that followed, but I certainly hope the writers of these books will not be talking with the talking heads on TV or radio. These people, that are on the air waves, are so ignorant of economics, and yet they talk as if they knew what they were talking about. It is not necessary to name names, but without the occasional professor of economics giving some serious commentary, the stuff we generally get from these talking heads is pure crap.

The system failed because the tools were not used properly. What do I mean? Let us take one tool of the investment industry, the credit ratings that are placed on debt instruments. The three major credit rating agencies will rate new debt obligations for the investment underwriters for a fee. This is pretty straight forward. The credit rating agencies inspects the new debt issue and check the coverage numbers, the ability and willingness of the borrower to pay principal and interest in a timely manner. Then after doing a fair amount of research into these factors that govern the final rating that is placed on the bond issue, the rating agency gives the new debt obligation a rating. The highest rating a credit rating agency can give is the Triple-A rating. There is not Triple-A plus or minus when it comes to Triple-A. With the Triple-A rating in hand the underwriter of the new bond issue then offers these bonds to investors. A large number of these investors are pension funds, mutual funds and some individual investors. Bond portfolio managers buy and then sell bond issues as they anticipate the movement of interest rates and the change in the credit rating of the bonds they hold in their portfolio. Credit ratings are live. Credit ratings are periodically reviewed and sometimes raised or lowered depending on the financial outlook of the borrower.

The mortgage-bond market meltdown came about as a result of the lack of research that was applied to the obligations that received the Triple-A rating from the credit rating agencies. The fact that these corporations were more interested in their bottom line than their responsibility to the investors that bought the bonds lead to the collapse of the mortgage-bond market.

This is a failure of the system. The concept of rating the willingness and ability of the borrower to pay back principal and interest in a timely manner is sound. The system has existed for many years and for the most part the credit rating agencies do a good job. The people that do the actual research on the borrowers are trying to do the best job they can, just as any professional tries to take pride in their work. The problem here arose when these credit rating companies became corporations where growth in earnings per share became the sword by which the CEO's salary and bonus cake would be sliced.

The failure of the regulatory bodies to realize that oversight of the greed factor was necessary lead to the passing out of the Triple-A ratings for the sake of profit. If the credit rating agencies did not come forth with the Triple-A rating for the new mortgage-backed bond issues, the underwriters would then shop the rating to another of the major credit rating corporations.

Eventually, the house of cards collapsed. Then the dominos of the financial industry started falling. The failure of the credit default market, the collapse of AIG and the general meltdown of the credit markets can, in my opinion, be traced back to the lack of regulatory oversight of the credit rating agencies. The system of using credit ratings for debt obligations can work, but only when the tool is used properly. Oversight is necessary to check the greed factor on Wall Street. There is no way around that.

Stay tuned.