Monday, May 3, 2010

A Systemic Flaw: The Credit Rating Agencies

If you hang around this planet long enough, you begin to realize that certain things are harder to change than others. Now, some of my contemporaries realized this right away and they left me in the dust years ago. I am a little slow to learn and perhaps observe things around me. Powerful institutions, where many people are involved, do not change direction on a dime. There are too many people involved and they have too much influence and also, there is a great deal of economic power on the table.

Sunday, The New York Times printed an editorial about the credit rating agencies, and in their opinion, the role they played in the recent financial crisis. This blog, MONEYTHOUGHTS, has been writing about the role that the credit rating agencies played in the bond market meltdown that lead to the financial crisis almost since its inception in February, 2008. I have even broken it down to the cellular level of the bond business, and tired to show how the Triple-A credit rating placed on a new issue of mortgage-backed bonds gave it a certain currency among bond portfolio managers.

Unlike the ratings given to corporations (corporate bond ratings) or municipalities and states (municipal bond ratings), where additional information about the issuer's ability and willingness to pay principal and interest in a timely manner is available from several sources, if one is inclined to do the research, this is not the case for mortgages bundled together and securitized into mortgage-backed bonds. While there is some information available to the mortgage-backed bond buyer, the details of each mortgage and the ability of each mortgagor to pay principal and interest must of necessity be assumed by the quality of the credit rating given by the rating agency.

I have written many times that, in my opinion, the housing bubble could not have been inflated without the help of the credit rating agencies and their willingness to give out their highest bond rating, the Triple-A rating, to the billions of dollars of mortgage-backed bonds that they rated. That in a nutshell made the eventual bond market meltdown possible.

Unless Congress takes a position and changes the way the credit rating agencies do business, we are all headed down that same road again. It might not be right away, but within a few years, after all this has passed, the weakness in the way the credit rating agencies operate will bring about another bubble, bond market meltdown to be followed by a financial crisis. A financial crisis is a fancy way of saying that there is no marketability of these bonds and thus the market makers find themselves in a liquidity crisis as market values fall.

Knowing that there are powerful forces lined up on the side of the status quo, I can not be too hopeful that real change will take place. The conflict of interest that the credit rating agencies have with the investment bankers that underwrite the new issues and pay for the credit rating will continue to present a systemic flaw.

Stay tuned.


Jientje said...

Let's hope change does take place?

winslow said...

When I was a kid, I always thought adults got together and decided on the BEST course of action to take (whether in business or politics) and then proceeded to make those changes. Now, it is way too obvious this does not occur. People can be misdirected by lies rather easily. I remember reading articles about the rating agencies years before the meldown....and no one in positions of authority seemed to care. I am so thankful there are individuals such as yourself that will tell the truth and what is best for our society.

moneythoughts said...

I think we all thought that adults did the right thing when we were very young, but that got knocked out of me pretty early in my development by bigoted teachers.

The problem is when a manner of business gets for lack of a better word "institutionalized" such as the case with the credit rating agencies, change comes hard because so many are involved in keeping things that way they are.

I think the Catholic Church has a big problem and while everyone knows what needs to be done, nevertheless, the Church's leadership can't seem to not get in its own way to do something about it. I think they want to deal with the problem, but they can't seem to make it go away. The problem has "institutionalized" itself over centuries. Change comes hard.