We have all heard about subprime collateralized debt obligations by now. Every day the media talk about how these synthesized derivatives are at the heart of the credit crisis. As more homeowners default on mortgages, the values of these CDOs continue to decline like a fast-moving avalanche.
Many people who buy bonds or debt obligations are looking for quality. They may be retired and do not wish to risk their principal on risky sub-prime mortgage debt so they buy AAA rated paper.
But have you ever asked who is doing the rating? Let me introduce you to our next roommate in the market's house of pain.
The three biggest ratings agencies, S&P, Moodys and Fitch, Inc. make profits by giving top ratings to securities.
Money managers rely on the ratings agencies to do the homework on a bond before buying it for a client.
Ratings agencies take into consideration the issuer's ability to repay, the interest rates and terms, and assign a letter or number to the bond with AAA and the number one being highest quality.
Those letters and numbers can be adjusted to reflect changes to the issuer. Those upgrades and downgrades give investors a heads up on the issuer's ability to repay the debt.
So how does all of this apply to the credit crisis? Because the ratings agencies were applying very high ratings to even the lowest trenches of subprime debt, relying on the now impossible belief that U.S. housing prices could only go up.
"The story of the credit rating agencies is a story of colossal failure," said Henry Waxman, chairman of the House Oversight and Government Reform committee as Congress investigates the credit crisis.
The committee put much of the blame on the ratings agencies for giving top ratings to complex securities backed by subprime mortgages.
This committee released documents showing that executives of the ratings agencies were well aware that there was little basis for giving AAA to thousands of mortgage derivatives, but the agencies did so anyway. High ratings allowed many subprime mortgage-backed bonds to be bought by mutual and pension funds that prohibit buying junk or low quality debt.
The fact that all this bad paper is everywhere accounts for some of the added volatility you see on your brokerage statements.
So what should have happened? In the past, high risk equaled low ratings and low prices. Those standards for risk should not have been ignored for profit.
Conflicts arose because ratings agencies got paid by the companies that underwrote and insured the bonds and not by the investors who bought them. It is clear that before investor confidence returns, many things must change.
So, do you have any of these in your portfolio? Possibly, yes.
Next time, how did all this tomfoolery get past regulatory agencies like the SEC?
The opinion expressed is that of Carol Perry and may not reflect the opinion of AWA Wealth Management or LPL.
- Carol Perry is a Northern Nevada resident since 1983.