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Wednesday, July 21, 2010

Paper, scissors, rock in the bond market

It seems that a last minute change in the financial reform bill just past has created what might be considered a small hiccup in the bond market. I am no fan of the bond rating agencies. Their behaviors in thew recent past played a central role in the real estate bubble which triggered the worst financial calamity in seventy years. Their ratings of mortgage backed securities, particularly the repackaged triple B rated bonds magically transformed into triple A rated CDOs , created an absolute mess.

Congress, in its desire to right the wrongs, added a measure to the reform bill at the eleventh hour which converted the bond ratings generated by Moody's, S&P, and Fitch, from an opinion (and not legally liable) to expert advice. Voila! Literally overnight the bond rating agencies go from having essentially no legal exposure to just being totally out there. Their response has been to put everything on hold.

I will not shed any tears for this incompetent triumvirate. They failed to serve any useful purpose and may have worsened the blowup in the mortgage bond market. However, there is a not so little problem. The functioning of the bond market requires the distribution of prospectuses and these documents are required to include ratings from these same bond rating agencies. No ratings, no complete prospectus. No complete prospectus, no new bond sales. Furthermore, the bond ratings are required for many investment entities to include specific paper in their portfolios.

So there we have it. In the midst of a fragile recovery (at best), the new financial reform legislation has frozen the bond market. I would have no problem if the rating agencies simply disappeared. Markets are pretty good and factoring in risk, unless they are lead astray by data derived from non-trustworthy sources such as... rating agencies. However the same entity which has overnight thrown the switch changing a product from one having no liability to infinite liability, has also previously mandated that the markets cannot function without this  same product.

Let recap:
1. New bonds require ratings
2. Ratings are fundamentally flawed
3. Rating agencies are now legally liable for their flawed products
4. Rating agencies are not willing to issue ratings if they are held to the new standard
5. No ratings, no new bonds

This can be easily fixed. Simply change nothing except lose the requirement for ratings. If the ratings agencies can actually create a useful product, they will survive.

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