While Y'all Were Kvetching About the Controversy Du Jour...Most Important News of the Year Happened

[alcibiades_mystery]

The Three Big Ratings Agencies (hereinafter, TBRA) are refusing to rate asset backed bonds due to the stepped up regulations of the financial reform package. This is ground-shattering news that already demonstrates the effectiveness of the new legislation. I'm going to tell you why.

Now, if you listen to CNBC or NPR's Marketplace, this is meant to be a Very Troubling Development. You see, according to existing securities regulations, you can't sell asset backed bonds without a ratings agency stamp on it that tells buyers the TBRA's "opinion" of their risk. That's a principle of transparency. You need an "objective" third party assessment of the risk for such bonds. If one of the TBRA doesn't rate the bond, you can't sell it. So, the bond market for asset backed bonds is at a dead stop: no ratings, no sales. Full stop.

So, what's the NEW problem? The financial legislation just signed into law makes the TBRA's liable for the opinion they give on a bond. If, for example, they give a bond a very strong rating (AAA, say), and the bond turns out to be junk, and it turns out that the ratings agency was negligent in its assessment, it can be sued by the bondholders. This has sent shockwaves through the financial set, but not only because it exposes the ratings agency and forces them to be honest in their assessment of the bonds. Rather, it pinpoints the precise pressure zone in the whole asset backed securities market and forces changes all the way down the line. They are screaming bloody murder and essentially blackmailing the government precisely because the new law cascades throughout the system. Here's how.

What is an asset backed security? Very simply, it is a bond that is collateralized with some other asset, usually loans on actual, concrete property. The most famous are, of course, mortgage backed securities, but any loan will do. I was once involved in an ABS deal in which the bond was backed with blocks of 1000 loans on Mack truck rigs. So, 1000 truckers pay their loan on their rig, and that loan is packaged in a deal that "secures" a bond. If the bondholders can't collect from the seller, they have recourse to those loans. Simple, yes? The financial crisis of 2007 can be traced to shenanigans with such bonds. Imagine, for instance, if I know that 750 of those truckers are behind on payments and likely to default. I still want to sell that bond, but I have to disclose this (theoretically), which means I will get less money for the bond, because the buyers will demand a higher interest rate. If nobody cares, I can use whatever shit loans I want. If somebody looks and cares, I lose money. Obviously, the buyer should be looking and caring, but this is really buttressed by the work of the ratings agency. So, what happens when the TBRA are on the hook legally for their ratings. This happens:

1) They give accurate ratings, rather than essentially "selling" good ratings to the issuer and underwriter.
2) The issuer and underwriter, knowing that the ratings agency will post an accurate rating, are incentivized to use only good loans in their bonds, or to sell their bonds with the accurate interest rate if many bad loans are included. Therefore, they will only buy/package good loans from the originator. No more 1000 block truck loans with 750 bad loans - or, we know that these will fetch a higher interest rate, and that the buyer will have priced in the risk. No more blind tranches.
3) Loan originators will no longer be incentivized to hand out bad loans and crazy loans to unfit borrowers, since they will have to eat the losses rather than selling them up the chain to the bond packagers. If you're unlikely to pay back your truck loan, I probably won't make it to you, since I won't be able to move that bad loan, and will therefore have to eat the loss on it.

In terms of identifying a point of pressure and pushing on it to achieve systemic cascade effects, that's a pretty impressive piece of the legislation. And you know it's good for the People precisely because the TBRAs are going ballistic over it, and the propaganda is flowing free and thick from the business class. This is system changing stuff we see at work here, as anyone who has ever worked in finance and on ABS knows damn well. And yes, this is the kind of change I voted for. :-)