Well think again, square! Old is the new new, black is last month's red, and incompetently rated asset backed securities are this weeks Chapter 11 bankruptcies (actually, Chapter 11 is still around too, but its probably unfashionably depressing to talk about because it doesn't have a cool acronym):
Standard & Poor’s has highlighted that many collateralised loan obligations – which pool leveraged loans and sell differently rated investment notes with varying risk profiles – have exposure to the same group of borrowers. The default of just one of these widely held borrowers on their debt could have a negative effect on the credit quality of the portfolios of nearly 90 per cent of European CLOs, the agency said in a report.
In fact, the debt of just 35 different borrowers appears in nearly half of the 184 CLO portfolios that S&P rates. In total, those funds hold at least €90bn in assets. (Source: Financial Times)
This is basically the same story that got bandied around the news a lot last summer when everyone was desperately trying to figure out where the world's economy went. Except the cast has changed ever so slightly--by one letter actually. Last year's revelation that the leading rating agencies categorically failed to properly identify the risk in CDOs (financial packages full of different bonds backed by different loans made to different little people who were trying to buy little houses and little cars and little college tuitions), has been replaced with the shocking bit of news that, by the way, those same rating agencies also failed to identify similar risk in CLOs (financial packages full of different bonds backed by different loans made to different big people who are trying to buy big factories and big regional banks and big CDOs).
If you don't follow what I'm saying, the details aren't particularly important. What I think is important is that:
a) the entire point of constructing these needlessly complicated securities (CDOs and CLOs) was to reduce the risk of investment. Loaning money to one person or one company is kind of risky; maybe there is a 10% chance that that person or company will default and the lender will lose out. Loaning money to a whole bunch of people and then repackaging their loans into little, fancily titled securities was thought to be less risky; the risk that all of these loans would stop performing (the debtor would default) simultaneously is significantly less than 10%. But with lax regulation and lax oversight--i.e. rating agencies failing to recognize that the debt of 35 companies is touching perhaps half of the market--these kinds of debt security markets have only amplified rather than dampened the risk.
b) It's been said many a-time but I'll say it again: the rating agencies that evaluate the relative riskiness of these securities either need to be nationalized or to see the very foundations of that industry's business practices reformed. These are private companies that are paid per rating by the companies for whom they are doing the rating. Obviously their customers want a high rating for their bonds and the rating agencies like to retain the business of their customers. Wouldn't it be nice if the Food and Drug Administration worked that way when it decided on whether or not to approve a new anti-depressant ? Or if EPA had to compete with other agencies to evaluate the sulfur emissions of a coal plant?* It doesn't take a Nobel prize winning economist to identify the problem here. In fact, at this point its probably best if we keep the Nobel prize winning economists in the other room for now.
*For the sake of my argument and mental health I am assuming that this is not how either the FDA or the EPA work.
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First, I am very surprised that this CLO business isn't getting bigger play in the media. This is a big, sad, terrifying story - if poorly-assessed CDOs led to a huge credit freeze in the paper money market, I can't imagine poorly-assessed CLOs will do anything different.
ReplyDeleteSecond, I've been hearing talk of nationalizing the rating agencies as well, and I think this makes a great deal of sense. A lot of anger has been (justifiably) directed at the rating agencies for their piss-poor record at doing the one thing they exist to do, and I think if you forced me at gunpoint to pick out the group of people who fucked our shit the worst in the last couple years it's probably them. The fact that they were privatized, to me, shows a fatal misunderstanding of how vital public regulation is to a healthy economy - having private rating agencies is the equivalent of a team bring its own ref to a hockey game.