Saturday, August 20, 2011

The Rating Industry collapse into what should be obscurity

This happened in 2008 and 2009. A probably known writer to a recent ENS post asked "how the rating agencies could have believed that if you bundled high risk mortgage loans the bundle then would become AAA." My brief answer was that rating agencies drank the kool aid like most of the market, they were greedy and happy, and in fact rating agencies are mostly financial clerks who were not capable enough or aggressive enough to be hired at leading Wall Street firms. Decisions were made by a few at the top whose compensation benefitted.

There is more to the story that goes a few years back. It's built around a belief that diversification and a belief in satisfying investor preference in order to more efficiently distribute loan originations by the big banks was a good idea. A couple of JPMorgan folks, Demchek and Masters I think, came up with the idea. Instead of just offloading originations in bulk to correspondants in need they organized loan originations into diversified tranches, such that investment managers could both diversify their risk and choose their risk profile(even conservative loan and bond funds wanted some sliver of higher yield and higher risk components to their portfolio to diffentiate their returns).

So while at the time not subject to ratings, these loan baskets functioned well for the most part, especially for the distributors. Fund managers could load up on high rated securities and then dabble in highly diversified lower rated, or high yield, securities to augment their returns.

It was really a remarkable idea for the syndicated loan market.

The concept then migrated to the rated securities markets with some mixed results but so much of the high tech bubble was financed with private equity that there was not a significant warning sign in the early 2000's.

But then the tranche security market hit the mortgage market, and worked well in the early years. There were the 20% payers in the top tranche, then the so-called Alt-A's, then the real sub-primes, then the immigrant cash no-docs, and finally the PICS, meaning no pay but just add to principle. This was a perverse interpretation of the original concept of loan diversification.

It somehow worked for the rating agencies as housing prices soared and the agency financial clerks took notes.

Then the entire market imploded and all mortgage securities became illiquid to some degree, regardless of tranche heirarchy. Lesser tranches collapsed and went into foreclosure meaning loss of principle and interest. Servicing firms were overwhelmed and completley understaffed and under managed for the debacle.

An initial constructive idea for the loan market in the late '90's became perverted almost beyond belief, and a complete absense of a look at the macro environment created a cataclysm of losses for the financial system from which we will not recover for at least three more years.

That's my long answer, JR, to your ENS question. My answer may be flawed and simplistic to real market professionals in many ways, but there are grains of truth here that would never be found in the NYT or WPost, just in my opinion.

The really frighening thought is that we are once again focusing on the mechanics of financial solutions and not a macro picture. How can a mediterranean beach resort, olive oil producer, and country of super rich and hyper corrupt tanker owners destroy Europe. How many Americans have seen most of prosperous Europe's infrastucture which makes the U.S. look like some quait relic of the 1960's. How can an infantile politial squapple in this country derail the world?

As in 2008, the macro environment seems to be lost on the populace of the world's most prosperous country with ultimately the most potential to be a leader. We need an answer, and a new awareness. We need a global look at the world's potential and a return to the optimism as expressed in the ENS post of July 30th on the absurdity of a balanced budget amendment to the Constitution.

We may need some divine help, but self proclaimers are always charlatans.

This is not a defense of the rating agencies folly but merely a chronology of how Wall Street and the agencies perverted what was once a sound idea.


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