February 18, 2008

How Subprime Really Works

This is the best and simplest explanation that I have seen on how the Subprime issue got started and how it became a problem:

click on Post Title to launch slide show

This "cartoon" has been floating around Wall St. for a few days and does the very best job of explaining how the subprime mess got started. Read it and get rightfully indignant. Not to beat the dead horse (right before I start beating the thing again), but in the whole course of events, as a financial person, I expect every bit of questionable activity in that slide show to take place UNTIL the Rating Agency part. They are the "protectors" of the investors. They are to be beyond reproach (hell, that's how they market themselves and their ratings have been a mainstay for the integrity of the entire credit market of the United States). One expects a certain amount of "used car salesmanship" from mortgage brokers and investment bankers and even the lenders. But the Rating Agencies are supposed to step in at the end and bring some sanity into a bond deal by rating crap as ... well, crap. I have seen the slow deterioration of the Rating Agencies during my 25 years in the private sector. Unlike, say a FASB which has always maintained an almost adversarial (too adversarial at times) relationship with private business, the Rating Agencies have gradually cozied up more and more with private business, especially the investment bankers. When an entity has a new debt issue, the issuing company PAYS Moodys and S&P to rate the thing. How much pressure does this cozy relationship that they've established with the investment banking firm that's underwriting the bond issue come into play, now? Don't answer - that was a trick question.

I'm afraid the Rating Agencies failure has set us up to have the government regulating bond ratings - one of the only ways to make a bad situation worse. Just imagine in this environment ratings being determined based upon totally subjective criteria - geographic location, gender, age, religion, and other demographics, etc... - in addition to also being sold like the current system apparently allows (don't forget to slip your Congress critter something to get your investment grade rating and to get the deal streamlined!). A thorough investigation of the Rating Agencies need to take place immediately and those analysts/managers/directors/executives who ultimately signed off on the investment grade ratings need to spend a few years in the jail, getting remedial math tutoring, in between dates with Bubba and shower-time fun and hijinx. (It would be poetic justice that those that did the screwing get on the receiving end of some of the same treatment that they meted out).

I'm also afraid that until the culpability of the relevant parties (i.e., the Rating Agencies) has been ferreted out and the total extent of the damage has been exposed,and a minimum course of action proposed to fix the current problem, that the performance of the US stock market is going to be mediocre at best. The integrity of the US capital markets has been seriously damaged. And if nothing more happens, we may eventually get lifted out of this current down-trending market - when investors feel that all of the bad news has been fully discounted by bond and equity prices. And this will last just as long until the next bomb goes off - which will definitely happen until there is some systematic change in the process.

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