By Alex Wallenwein, Editor, Publisher | 8 February 2008
The EURO vs DOLLAR MONITOR
(NOTE: Please scroll down to the end for an urgent UPDATE on this article— 2/8/08)
So you thought the Ambac/MBIA bond insurers crisis was bad?
You ain’t seen nothin' yet
The problem, the challenge, the scandal, is not that the bond insurers are about to be downgraded. The real scandal lies in the fact that they haven’t been downgraded a long time ago— and much deeper than from "AAA" to "AA”. In fact, what needs to be downgraded are the major international credit ratings agencies, Moody’s, Standard & Poor, and Fitch. Ironically, they are already in the process of downgrading themselves. Moody's, for example, recently issued a statement cautioning investors not to rely on its ratings so exclusively. Ha! That's worse than a corporate CFO saying investors shouldn't rely on the company's financial statements so much when making their decisions to purchase or sell.
Why Downgrade the Ratings Agencies?
Why do they need to be downgraded? Because the top three or four ratings agencies have been (snd still are) ridiculously behind the curve when it comes to letting investors know about problems with the entities whose credit standing and investment outlook they (pretend to) rate. The reason for that appears to be an unresolvable conflict of interest which emanates from how these agencies get paid [[actually the reality is a little less criminal but even more dire— the rating agencies are seriously deficient in the 'quants' needed to understand all of this new breed of untested, esoteric paper, so they 'wing' it, relying instead mostly on the untested theoretical models and stats provided by the authors of these exotic financial vehicles themselves: normxxx]]. But that they get paid for their services by the companies (and governments) whose performance they rate does no harm in how well they trust the information they receive. (You mean, not everyone on Wall Street is honest?)
Somewhere in the distant past, in the early 1970s, they were paid by the investors who needed to tap them for their information, so investors could make reasonably reliably informed and educated judgments on investment risks. That is no longer so. Now, they serve two masters at the same time— but only one master really gets the benefit: the one who pays them. Unfortunately, the ones left in the dust in this scenario are the world’s institutional, professional and amateur investors, who stand to gain or lose the most, and who most influence the prices of investment products (based on those ratings).
What’s the Big Deal?
The ratings agencies are the paper investing world’s equivalent of an air traffic control system. Institutional and professional investors, particularly, rely on them almost exclusively when deciding whose debt paper to buy and whose to ditch and how much to pay. Picture yourself as the pilot of a big airliner. It is nighttime, it’s foggy, and you need to land. The question is: are the runway and the landing approach clear? You communicate with the tower of the airport of your destination, and you hear: "Oh sure,go ahead" through your earphones, so you commence your landing approach. What you don’t realize, though, is that the way the air controllers get compensated has just been changed. Note: this is just a hypothetical example!
No longer do they get bonuses just for sterling records of no accidents over some period of time. Now, they get paid extra if they can manage to land as many airliners as possible— concurrently! You can probably see where that might cause a little problem. In other words, you can't rely on the air controllers' directives with quite the same faith as before— but you don't know that. So you almost crash-land your plane, just narrowly escaping an in-air collision with another plane, and only then do you start asking questions.
The world's institutional investors are as dependent on the accuracy of the agencies' ratings as airline pilots are on air traffic controllers, but just as in our analogy, the change in payment structure has somewhat compromised the interests of the originator of the information. One result of this conflict of interest is that, according to an interview with Sean Egan of Egan-Jones Ratings aired on CNBC Friday, February 1, 2008, the ratings agencies’ bank and Wall Street investment house customers have actually exerted pressure on the agencies to issue ratings on CDOs— the very subprime mortgage-backed instruments that caused the current credit crunch!
As if that wasn't bad enough, the ratings agencies then reportedly began to demand that bond insurers develop "mutiple streams of income" in order to get their coveted "AAA" ratings— and that entailed insuring bond derivatives as well, which ultimately benefited Wall Street (since those derivatives thereby acquired the ratings of the insurer) and the bankers, who wanted to push as much of that 'toxic' stuff into the markets as they could as fast as they could— thereby earning huge fees and bonuses. Naturally, the insurance companies and rating agencies wound up acceding to the requests from their ultimate Wall Street customers, which is now largely responsible for causing them the very subprime-related damages they are now being punished for. Funny how that works, isn't it?
The Upshot.
The upshot of all this is that the entire global professional investing world has traditionally heavily relied on these ratings outfits in making investment decisions. "AAA”ratings (normally reserved for sound, sovereign governments and few others) that used to be regarded as immovable, solid landmarks in the investment landscape (with far less than a 1% chance of default) now turn out to be nothing more than shape-shifting phantoms. In fact Egan-Jones, which is a relatively new ratings agency that decided to follow the old model of getting investors to pay for their services, rates MBIA not "AA" (to where Moody’s wants to downgrade it) but only a mere BB+, which is essentially junk status.
There is no telling how many other companies and bond-issuing governmental entities might be similarly affected. Quite tellingly, and in anticipation of potential future criticism, Moody’s has recently warned that it may have to downgrade the United States of America’s credit rating. There are international efforts underway to "fix" the coming ratings disaster by making the companies adhere to "higher ethical standards". Yeah, right. That has always helped, hasn’t it? Just think "Sarbanes-Oxley". The only thing that will fix the problem is to prohibit the ratings companies from accepting money from the institutions they rate. Period.
But, regardless of how, whether, and when the ratings companies themselves will get fixed, the neglect they have shown in the past has already caused severe, systemic problems. That malfeasance is opening up a veritable maelstrom, a black hole for international credit ratings [[and litigation— lawyers; lots of lawyers: normxxx]]. The collective reputation of these agencies has essentially provided the "value" for many of these bank and government-issued debt instruments for the past three decades— and now that "value" is threatening to collapse [[along with the reputations of the credit ratings' agencies: normxxx]].
The question now is: on how many— and on which ones— of these credit ratings did they goof up? Six years ago they failed to warn of Enron, Worldcom, and others in a timely fashion. Now, it’s Ambac and MBIA. Who’s next? The very fact that these agencies have been whitewashing their clients’ credit ratings over the past several decades throws every single rating they have issued into doubt. That means there are likely to be huge numbers of bone-deep ratings cuts coming down the pike— and nobody knows which ones, or how deep those cuts will be [[so all lenders are 'hoarding' their money— better safe than sorry: normxxx]]. One thing, however, is almost for certain: The very fact that Moody’s has warned of a credit downgrade for the United States indicates that such a downgrade is probably long overdue— and that will spook a whole lot of international US treasury investors— like China, India, Japan, and Saudi Arabia. [[Note: it already has! : normxxx]]
Let that sink in for a moment.
When companies and governments get downgraded like this, they must offer far higher returns on their debt paper to attract future investors— and that raises interest rates. Considering how far these ratings' outfits appear to be behind the curve, that means the world is likely anticipating a humongous jump in both long and short term interest rates— and that in spite of the US Fed’s desperate and frantic attempts to lower short term borrowing costs [[and steepen the treasury yield curve to the benefit of the banks and speculators, who borrow 'short'— at low rates, from the government/taxpayer— and lend 'long'— at high rates, to you and me (have you checked your credit card rates lately?): normxxx]].
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Interest Rates Will Have to Rise.
Unfortunately, as far as most government bonds are concerned, higher returns mean that a lot of bonds have to be sold because, with bonds, yields are an inverse function of price. For the yield to go up, the price must go down, and that means selling, selling, selling. The astute investor will anticipate that— and get the hell out of bonds of any kind [[at least of bonds of more than 1-year duration: normxxx]]. And, oh yeah, as interest rates rise rapidly across the board, companies will find it more expensive to borrow money, so it gets harder to make profits (which is already pretty damn hard these days) and that means stocks and the economy will suffer as well.
Where do you think all of that newly homeless investment capital will go? It will seek a safe haven— but bonds, especially those of the US government kind, will long since have lost that status by then, even in paper investors’ minds. That just about leaves only gold [[or other scarce mineral things; "stuff", as opposed to "paper": normxxx]], its precious metallic cousins, and related investment vehicles such as precious metals ETFs, stocks, and mining mutual funds with any hope of decent returns. It will be very interesting to watch this happen: millions of investors, institutional and private, all rushing to invest in only a handful of companies, while bidding down the price of fiat money.
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Got Gold?
February 6, 2008
UPDATE:
Here is an excerpt from an Associated Press article of 2/7/08:
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COMMENT: Expect more of the same. Much more! There will be hell to pay by investors for the US ratings agencies' failure to accurately and timely rate sovereign debt risks.
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Normxxx
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