Lowenstein on the Ratings Agencies

By Reuters Staff
April 23, 2008

The Sunday Times Magazine will be publishing a fascinating article regarding the credit rating agencies and the role they have played in the housing bubble. (The introductory paragraphs of the article are below; the full article is available at the link above.)

In the course of describing the rating agencies’ failures, Roger Lowenstein also offers the clearest explanation of mortgage backed securities (MBS) and collateralized debt obligations (CDOs) that I’ve seen to date.

In 1996, Thomas Friedman, the New York Times columnist, remarked on “The NewsHour With Jim Lehrer” that there were two superpowers in the world — the United States and Moody’s bond-rating service — and it was sometimes unclear which was more powerful. Moody’s was then a private company that rated corporate bonds, but it was, already, spreading its wings into the exotic business of rating securities backed by pools of residential mortgages.

Obscure and dry-seeming as it was, this business offered a certain magic. The magic consisted of turning risky mortgages into investments that would be suitable for investors who would know nothing about the underlying loans. To get why this is impressive, you have to think about all that determines whether a mortgage is safe. Who owns the property? What is his or her income? Bundle hundreds of mortgages into a single security and the questions multiply; no investor could begin to answer them. But suppose the security had a rating. If it were rated triple-A by a firm like Moody’s, then the investor could forget about the underlying mortgages. He wouldn’t need to know what properties were in the pool, only that the pool was triple-A — it was just as safe, in theory, as other triple-A securities…..

I should note that I finally got around to reading his book on the failure of hedge fund Long Term Capital Management last August. It was about that time I was getting antsy about my Citigroup stock. Read that book, which awakened me to the dangers of leverage on Wall Street, and decided to punt Citigroup the next day. Got out at $47. That book, “When Genius Failed,” is a lightning fast read that I recommend VERY highly, especially in this market environment.

(He also wrote the definitive biography of Warren Buffett, another great read.)

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