Corruption or what? CDOs, Treasuries and Credit Ratings...

CDOs and Treasury Bonds - Risk, Return, and Credit Ratings? We aren't economists, but something sure seems wrong.

PLEASE - set us straight if we are off base here...   

OK, if two fixed income investments have the same risk profile, they should offer the same return (or something very close to it).  Right?

If so, then are we right to assume that two classes of fixed income investments stamped with the same credit rating should have very similar risk characteristics?  If one investment offers higher returns with no added risk, common sense (and, we presume, the science of economics) dictates that rational investors will choose the higher yielding investment product.  

So far, so good?  If so, then what in the world were the Credit Rating Agencies doing during the housing bubble?   

A huge volume of mortgage-backed securities (MBS) and related investments like collateralized debt obligations (CDO's) received AAA credit-ratings and offered investors yields that, for several years, were superior to AAA U.S. bonds.  To managers of massive pension funds, sovereign wealth funds, and other investors, a AAA credit-rating means there is virtually zero risk of default (we looked that one up). Therefore, the only logical conclusion is that Moody's, S&P, and Fitch told investors that certain mortgage securities were pretty much impregnable, just like obligations of the United States government.  

It seems kind of clear to us that no fund manager would purchase super safe U.S. government bonds when investments in high-rated tranches of MBS and CDO's carried higher yields with no added risk? Predictably, demand for mortgage-related securities skyrocketed.

In nearly every case, investors relied on credit ratings.  Institutions believed the CDOs were safe.  AAA means AAA, and because financial engineers at places like Bear Stearns and Lehman brothers were able to slice and dice the cash flow from all kinds of mortgages in ways that were too complex for practically anyone to truly understand, even sophisticated investors were unable to do any independent risk assessment.  

Again, it is our understanding that the basic risk-reward principle dictates that two or more AAA-rated fixed income investments issued in the same interest rate environment should produce virtually identical returns.  Is there some basic fact or principle that Wall Street Law blog is missing?  And yet...

Vast quantities of AAA-rated mortgage-backed securities and CDOs consistently promised and, until the credit bubble started to leak, actually delivered significantly higher yields than AAA-rated U.S. Treasury bonds (which are, of course, guaranteed by the full faith and credit of the United States Government). 

All of this leads us to one of two conclusions -

EITHER-  

The science of economics and/or the business of credit ratings are farsical-

-OR- 

Wall Streeters like Merrill Lynch, Lehman Brothers and Bear Stearns colluded with the major credit rating agencies to obtain bogus investment grade ratings (at least for AAA tranches) in order to maximize the universe of potential investors for CDOs.  

If we have this stuff way wrong (and maybe we do), we'd sure like to hear what really happened and where our amateur analysis went awry.      

The Sherman Law Firm

Comments

[Bds]

RESPONSE to READER COMMENTS

Paul - thank you very much for taking the time to comment. We will be sure to read your CDO article.

Sincerely,

Wall Street Law Blog

[Paul Mason]

Hi there.

I have just read this article - found it very interesting..
I have followed the financial market meltdown closely from Australia.
I like the level of cynicism in your article - i think if more analysts were more cyncial, there would be far less mistakes..

One point that you may have missed is this.
Many (not all) CDO's were underwritten prior to issuing by major insurance companies (think AIG!). Therefore, the credit ratings companies gave them AAA ratings becuase they were only rating the CDO.. not the insurance company that had underwritten them.. this also explains how CDO's spread so far across the industry.

And in most cases - CDO's did yeild significantly higher than Gov backed securites.

I have written an article that helps to explain the CDO structure by comparing them to Bananas. I think you will enjoy.

Regards,

Paul
http://behindthefinance.blogspot.com