One of the many parts of the financial crisises that the average investor doesn't yet realize is how it was made possible by the sheer incompetence and negligence of the credit rating agencies: S&P, Moody's and Fitch.
Fund Managers Relied on These Agencies
Financial institutions and hedge funds around the world bought mortgage-backed securities not simply because they trusted American home owners, but because they trusted these rating companies to give poor scores to poor investments.
Yet the Wall Street firms packaged subprime mortgages into collateralized debt obligations (CDO) that were rated double A or the equivalent even though the mortgages behind them were shaky at best.
Bond traders sold these to companies such as American Insurance Group (AIG) and others.
Are These Agencies Staffed by Second-Raters?
Michael Lewis, in his terrific new book THE BIG SHORT, describes the employees of the rating companies as people too unintelligent to get a job at the major Wall Street firms.
After all, wouldn't you rather be a million dollar per year analyst on Wall Street than a hundred grand per year analyst for Moody's?
The best that Moody's and S&P (Fitch exists, but is so small and unimportant it's rarely mentioned) did when presented with these mortgage bonds was obtain the average FICO score of the borrowers.
Their FICO score supposedly represents their ability to pay back the money they borrow.
The Credit Rating Agencies Let Down Their Clients
Employees at Moody's and S&P never got a clue that Wall Street bond traders were gaming the system. They packaged a bunch of subprime mortgages from homeowners with low credit scores, then throw in a few mortgages from people with high credit scores. The average FICO score of the bond was then average, but in reality most of the bond was composed of the kind of mortgage note owners most likely to be unable to pay if the monthly amount went up.
Also, they seemed to have no comprehension that many of the high FICO scores were called "thin FICO." That meant the borrowers had high credit scores because they'd never had a late payment -- because they'd never borrowed money in America before. They were immigrants. That's not bad by itself, but most of them had low incomes.
Rating companies apparently did not realize that many subprime mortgage companies were doing "no doc" deals -- better known as liar loans. All people had to do was say they income high enough to qualify.
Nobody outside the mortgage industry, the home buyers themselves, and the Wall Street traders, seemed to realize how prevalent this mortgage fraud was.
Mortgage Fraud Became Widespread, but Few Noticed and Fewer Cared
In early 2007 I did research for a client on how the financial ratios you needed to meet to get a mortgage. That is, the client wanted an article on debt to income ratios, credit scores and so on. If you bought a house before 2000, you know that bankers used to take these rules of thumb seriously. If your income was too low or your other debt was too high, you didn't get the loan. Period.
Eventually I found an article online explaining that all the old qualifications had been thrown out the window, but I found it difficult to believe. I'd had to jump through many hoops and come up with a 5% down payment to buy my two houses. Why would that change?
And even that article understated the truth of people on welfare and working minimum wage jobs being approved for mortgages to buy houses worth hundreds of thousands of dollars.
Most Americans were too busy working at their own jobs and businesses to pay attention to the shenanigans going on in the mortgage industry. But what's the excuse of employees of Moody's and Standard & Poor's?
Checking things out is their job. Maybe they're not paid small fortunes because they're not on Wall Street, but I'd bet the responsible ones are paid more than I ever made at my job.
However, although Lehman Brothers is gone, and Bear Stearns and others are transformed by the crisis, Moody's and S&P are still evaluating credit risk, and the markets still take their scores seriously.
Besides, what's the alternative?
If Moody's and S&P can't tell you whether a bond is investment quality or junk, who can? Who else could perform the due diligence?
High Quality Due Diligence is Labor -- and Brains and Courage -- Intensive, and Therefore Expensive
As explained in THE BIG SHORT, a few hedge fund managers did dig deeply into the situation, and made fortunes from shorting the mortgage-backed securities. One of them, hated by his investors even after he made them a lot of money by being proven correct, left the business.
But who can do an honest, thorough evaluation of every company, municipality and government issuing bonds?
Nobody. So income investors should take all credit ratings with a grain of salt, and be aware of what's behind the securities they pay.
We're Too Small to Be Targets for the Biggest Wall Street Thieves
For one thing -- and I don't know about you -- but no bond trader on Wall Street called me up wanting me to buy a few hundred million dollars worth of mortgage backed securities.
Average investors -- which everybody with under a billion dollars to invest -- are too small for the truly ruthless and greedy big time traders to mess around with. They go after institutions and hedge funds with large amounts of cash to spend.
The bonds we can buy -- federal, municipal and corporate -- are very simple, ordinary and plain vanilla compared to the complex derivative products Wall Street bamboozled the big boys with.
Of course, we still fear default because -- however small by Wall Street standards -- our personal retirement portfolios are important to us.
Take All Credit Ratings with a Big Grain of Salt
Personally, I think it's foolish to buy any bond of less than investment grade, though I realize many people buy junk bonds for the extra yield.
It may be a justifiable risk in "normal" times, but we're not in normal times now. And even if the economy is back to "normal" when you read this, I promise you that in the long run (which is where all small time income investors should be investing for), you're going to see a lot more bad markets and financial problems.
That doesn't mean I believe all highly rated investments deserve their ratings. It just means I recognize my limitations. And I believe the odds are that highly rated companies are in better condition than companies issuing junk bonds.
That may not mean they're in "good" condition -- just better than outright junk bonds.
One important lesson from the crisis we can learn from, however, is that when the you-know-what hits the fan, the credit ratings don't mean a whole lot.
Prepare for the Worst, Because We Can't Depend on the Credit Rating Agencies to Protect Us -- Powerful Storms Sink Battle Ships as Well as Rowboats
Some of the short traders in Wall Street figured that out from analyzing mortgages. Even the "A" mortgages -- people with decent incomes and high credit scores -- would be at high risk of foreclosure if their home values went down a lot or they lost their jobs in a recession.
If we enter worse economic turmoil, we may find weak companies pulling down strong companies, just as Greece is pulling down Germany in Europe.
Therefore, the best protection for an income investor is to concentrate on businesses supplying people with their basic needs, and to diversify.
Author Resource:
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