Roger Lowenstein on the Bond Rating Agencies

Here is the article that Eben was talking about the other day in class regarding the rating agencies' conflict of interest with their clients as a culpably contributing factor to billions of dollars in bank write-offs and tens of thousands of jobs lost.

A great quote relevant to our reading of Arthur Leff's Ponzi scheme is reproduced below. What do you think of the conclusion at the end of the paragraph?

"The analyst wasn’t evaluating the mortgages but, rather, the bonds issued by the investment vehicle created to house them. A so-called special-purpose vehicle — a ghost corporation with no people or furniture and no assets either until the deal was struck — would purchase the mortgages. Thereafter, monthly payments from the homeowners would go to the S.P.V. The S.P.V. would finance itself by selling bonds. The question for Moody’s was whether the inflow of mortgage checks would cover the outgoing payments to bondholders. From the investment bank’s point of view, the key to the deal was obtaining a triple-A rating — without which the deal wouldn’t be profitable. That a vehicle backed by subprime mortgages could borrow at triple-A rates seems like a trick of finance. “People say, ‘How can you create triple-A out of B-rated paper?’ ” notes Arturo Cifuentes, a former Moody’s credit analyst who now designs credit instruments. It may seem like a scam, but it’s not."

-- JesseCreed - 27 Apr 2008

Roger Lowenstein is using a strategy of construction that you have interrupted. The reason for his conclusion that it's not a scam is found in the following paragraph, from which you don't quote, so the reader who hasn't absorbed the text carefully won't be able to give the answer and may think s/he's supposed to be able to do so based on what you have quoted.

The reason it is not a scam is that the bonds made out of the combinations of mortgages represent different levels of priority in getting paid the money produced by people making payments on all those mortgages. A bond issued for the first 10% of the revenue would be sure to pay off even if 90% of the mortgages defaulted. That one would surely be triple-A, and would bear a low interest rate. Later segments of the stream of revenue from the mortgages would be sure to pay even if lower proportions of the mortgages stayed current, and those would bear lower ratings and higher rates of return. The rating agency and the packager of the bonds run the numbers and try to agree where the loss risks are, aggregately, and then structure a stack of bond offerings that parcel out those risks, with appropriate rewards for taking them. If everything is as it looks and the risk ratings agreed to are right, the Aaa parts are in fact triple-A, while the Baa or Bbb parts are also there in appropriate array. That's not a scam. But if the risks are misrepresented it's a scam, and if they're only misunderstood, it's a catastrophe waiting to happen.

-- EbenMoglen - 27 Apr 2008