Friday, April 23, 2010
And Now The Rest Of The Story
It now appears that the investigation into the bond market meltdown and the financial crisis that followed has finally reached down to what I will call, "the cellular level". Namely, the credit rating agencies that slapped their Triple-A ratings on all those mortgage-backed bonds are now going under the microscope. Documents have been subpoenaed from Moody's and soon the whole story will unfold.
As I have written many times, this is not rocket science or brain surgery to understand how the credit rating agencies were the conduit through which the mortgage bubble was inflated.
Many years ago, when I was a bond trader/municipal bond portfolio manager with a trust department in Cincinnati, and even before that, when I was a municipal bond salesman, I had come to know the credit rating agencies and their weakness to political pressure. In the early 1970s, the City of New York had their general obligation (GO) municipal bonds downgraded by Moody's on one day, and on the very next day, their single A rating was restored. You see, a trust department could hold onto a Baa credit if it was already in the portfolio, but they could not buy a new issue of City of New York GOs with the lower credit rating.
Later Michael Milken, after studying credit ratings and the small number that actually went into default, created a junk bond market also known as high yield corporate bonds. Bonds that had been downgraded were referred to as "fallen angels", but Milken took it one step further by bringing lower rated bonds(below investment grade) to market as new issues. This period was followed by the creation of structured finance and collateralized mortgage obligations (CMOs).
But, during all of this, the credit rating placed on a new issue remained a very important factor in any bond portfolio manager's decision to purchase a new issue that had no track record. This is where the Triple-A credit rating came in. The underwriter of a new issue of mortgage-backed bonds with a Triple-A bond rating could then offer this attractive yield bond in a climate of low interest rates. Pension funds and every other institutional investment portfolio that had to invest a portion of their assets in fixed income securities was looking for higher yields and thus a higher total rate of return for their clients. The mortgage-backed bond with its Triple-A credit rating and higher relative yield filled that need for portfolio managers to outperform their benchmark.
The only thing left to do to ensure that the flow of bond rating business continued to come in was that the Triple-A bond rating had to be given to all the new issues brought to the credit rating agencies for their stamp of approval. The underwriters made it clear that if the Triple-A bond rating was not forth coming that other credit rating agencies would then get the business. The credit rating agencies were publicly traded corporation with boards of directors and CEOs needed to show growth in earnings. The growth in the bond rating business was coming from the CMO business, and thus the earning per share (EPS) of these corporations grew. It should not be too hard to trace the growth in EPS to the explosion of the CMO market.
The fraud that the investigation will uncover will be the conspiracy to mint mortgage-backed bonds that did not qualify for the Triple-A rating, but were given the Triple-A rating regardless of the fact and numbers that they simple did not qualify for the highest rating given by the credit rating agencies. Once the new issue is placed by the underwriters of the mortgage-backed bonds, the underwriters have nothing to do with the issue of bonds. What happens now rests on the heads of those bond portfolio managers that bought those new issues. When the credit rating agencies downgraded the mortgage-backed bonds as a result of the mounting mortgage defaults, the ratings were lowered. When the ratings were lowered, the trading desks stopped bidding on these bonds. When the bond traders stop bidding on bonds, you have a bond market meltdown. End of story.