How Subprime Junk Got the “Good Housekeeping” Seal of Approval .... Part I

A few years ago, in the wake of the bankruptcies of former blue-chips like Enron and WorldCom (among others) the fallout reached far and wide. Wall Street brokerage firms entered into a multi-billion settlement over their “tainted research.”

Wall Street analysts had been pressured to keep favorable ratings on stocks in the go-go years of the late 1990’s. At the same time these analysts were saying privately (unfortunately for them in emails) that these same buy-rated stocks were “pigs” with share prices “going to zero.”

The collateral damage also reached into the hallowed halls of the big accounting firms, since too many were looking the other way when fraudulent accounting was taking place at Enron and many other such firms.

When such obvious conflicts of interest came to light, the lawsuits quickly piled up. Wall Street brokers, specifically its conflicted research, became another collateral casualty of the dot.com bust.

Another Subprime Casualty Waiting in the Wings

Today, it’s the fallout from the sub-prime housing bust that’s impacting Wall Street, and the collateral damage may soon create another casualty of the credit crunch – Wall Street’s supposedly “independent” credit rating agencies. A recent article in Bloomberg details the whole sordid mess.

Near the peak of the late-great U.S. housing boom, “Wall Street marketed a new type of security backed by high-interest subprime mortgages issued to the least credit- worthy homebuyers.” The Wall Street money machine has never come up short on innovation, churning out exotic new products at the blink of an eye.

Subprime mortgage backed securities were just such a shiny new “product” created by the wizards of finance. But since investors might question the quality of a security called “sub-prime”, Wall Street needed a helping hand to sell its new securities. They need favorable credit ratings.

Big institutional investors such as pension funds, mutual funds, and most state and local government investment funds must follow strict rules that prohibit them “from buying securities that don’t carry investment-grade ratings.” These institutional investors are Wall Street’s bread-and-butter, so an investment-grade rating was essential in selling sub-prime.

Wall Street Lobbies the Big-Three Ratings Agencies

Wall Street get a very BIG helping hand in its windfall of subprime bond sales, thanks to favorable credit ratings provided by “the big three” independent rating agencies: Standard & Poor’s, Moody’s Investor Service, and Fitch Ratings.

These three firms basically own a monopoly on the market for credit ratings assigned to corporate bonds and other securities. This is Wall Street’s version of the Good Housekeeping Seal of Approval. The rating agencies play a key role in new bond issues as the Consumer Reports if you will, rating the quality and claims-paying ability of new securities.

In need of favorable investment-grade credit ratings to peddle subpirme to institutional buyers, Wall Street firms took it upon themselves to lobby the ratings agencies about the virtues of these new securities.

Unfortunately for the investors who bought this junk, the big-three rating agencies were only too willing to oblige Wall Street.

As it turns out, nearly 80% of the sub-prime mortgage backed bonds issued as the housing boom faded in 2005 and 2006 “carried AAA ratings, the same designation given to U.S. Treasury bonds. Blessed by the biggest credit rating companies as safe investments, these instruments offered higher returns than government bonds with the same ratings.”

It looked like the perfect security…at least on paper! As a result, Wall Street sold over one trillion dollars of sub-prime securities in 2005 and 2006 alone – much of this junk carried investment-grade ratings.