Michael
Milken, the financier who revolutionized corporate finance
in the 1980s, based his entire concept of junk bonds, on
what he claimed was a “fundamental flaw” in
Wall Street’s financial structure: the trust it had
in the ability of three ratings services– Standard
& Poor’s, s Moody's and Fitch Ratings– to
evaluate the relative risk of bonds. Since SEC rules prevented
anyone else from supplying bond ratings, these rating services
had (and still have) what is tantamount to a global monopoly
on issuing bond ratings. When one or more of these services
give a triple-A rating to a corporate bond, it certifies
that there is virtually no risk of default, This seal of
approval allows Wall Street underwriters to sell them to
insurance companies, pension plans, college endowments,
and other institutions, many of which are restricted by
regulations from buying bonds with a lower rating that triple-A.
In other words rating services determined which corporations
are eligible for institutional bond financing.
When I interviewed Michael
Milken back in 1987, he railed against the rating services,
zeroing-in on Triple-A rated banks such as Citibank. His
scathing analysis went as follows: "What is a bank?"
he asked rhetorically. "It is nothing more than a bunch
of loans." " How safe are these loans?" he
continued.
"They are made mainly to three groups that may never
repay them in a real
economic crisis-- home owners, farmers and consumers of
big ticket items." "What
guarantees these loans?" "Very little since these
banks usually have $100 in loans
for every dollar of equity.” He pointed out that a
number of states such as California required that all home
loans be non-recourse loans, which means that the only collateral
is the home itself (making them little better than what
would later be called sub-prime mortgages.) “Yet,their
bonds get a triple-A ratings from the bond rating services."
ne continued. "This is crazy" because rating services
measure "the past not the future" risk.
Soon afterwards, the financial establishment trounced on
Milken. Faced with endless litigation. He pled guilty to
the five counts of financial transgression, and went to
prison for 22 months. But his downfall did not answer the
critical issues he raised about the rating services.
That was two decades ago. Since then the rating services
have extended their
Triple A ratings to debt packages, such as Collateral Debt
Obligations (CDOs) that
included subprime mortgages and other questionable loans.
Since they get much
higher fees for rating complex debt pools than for plain
vanilla corporate bonds,
this expansion into CDOs has proved incredibly lucrative
for them. Moody's,
which is partly owned by Warren Buffet’s Berkshire
Hathaway, raked in over $3
billion in fees from 2002 until 2006 for providing these
ratings. Standard &
Poor's meanwhile escalated this race into the abyss in 2000
by extending
their top ratings to “piggy-backed” CD0s. Appropriately
named, piggy-backed CDOs multiplied leverage by allowing
buyers to simultaneously take out a second loan to finance
the first CDO. The logic was that if the initial loan was
Triple A, and there could not default, so was the “piggy-back”
based on it. Other rating services followed suit, so as
not to lose the rich piggy-back rating business to Standard
and Poor’s. The result that CDOs were leveraged over
and over again, while maintaining the triple-A rating that
made
them appear to be almost as safe as a Treasury bond.
Of course, there is an obvious conflict of interest in this
enterprise: the rating services are paid by the companies
who issue the securities they rate. Moreover, the rating
services admit in their fine print that their ratings are
based on the data supplied by the companies seeking the
ratings. Nevertheless, wheelers and dealers in Wall Street,
London, Dubai, and other financial ports of call so leverage
these rated CDOs to such an extent that by late 2008 an
estimated 18 trillion dollars in marketable debt hung over
what remained of the global financial markets. As we all
know now. the ratings proved to be wildly out of touch with
reality, and the subsequent collapse of the house of cards
built upon them, sapped the global financial system of the
crucial confidence necessary for it to function..
If Milken’s critique of the rating services had been
taken more seriously
in 1987, we might not now be staring into this back hole
today,
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