The Great Collapse Part 5: Rate me, do it again and again, C'mon and rate me...

Alrighty then. We now have most of the basic pieces we're going to need to start constructing the financial shenanigans that got us to where we are. So now we start slotting them into place.

Last time, we looked at how Solomon had the revolutionary idea of slicing mortgage bundles into tranches in order to create more appetizing investments out of them.

But if I am an investor, how do I know which bonds are the good ones? And when Solomon or whoever wants to start selling pieces of one of these tranches (or, if I'm running a massive investment fund, perhaps the whole tranche all at once) how can I tell how good it is?

One way would be to do some heavy research myself. This would be costly and time-consuming. So, the market being what it is, a long time ago some folk had the bright idea to do the heavy research for you and publish lists of the results. Literally just lists of possible bonds and a rating for them, based on the research and opinion of these rating agencies.

These people were named things like Moody and Poor. The firms they started are still around, Moody's, Standard & Poor's and the other one are the big three. Yes, I could look up a reminder of the other one's name, but in groups of three isn't there always an "other one"? Like with the three tenors, or the three stooges, or whatever? (OK, fine. It's Fitch. Are you happy now? Fascist.)

So the big three rating agencies rate stuff. Companies, mostly. Which, in practice, means rating their bonds. Meaning rating how likely they are to pay off their obligations. They give grades like "AAA" or "AA-" or the like. So then investors looking to buy them know what an appropriate amount of interest might be.

Also, when making financial contracts between corporations, lots of times you'll have certain things be contingent on the credit ratings of the parties. Things like how much collateral you want to hold for them. In an insurance contract, say, for a large deductible policy, the insurance company often puts out the money for the deductible and then collects it back from the company later. Which means that the insurance company really wants to be sure the company will be able to pay. So they'll ask to hold some funds up front and the amount of funds will be highly determined by the company's credit rating by one of the big three. (This, too, will be very important towards the end of our saga.)

So the folk creating these tranches of securitized mortgages had the rating agencies rate them so they could sell them. And here, ladies and gentlemen, is a first part of the problem. The rating agencies are private companies trying to make money. They are also officially recognized by the government for their rating of companies. These two roles can be in conflict with each other. And were.

When these i-bankers started coming in with their snappy new tranche structures to be rated, the rating agencies charge them for the service. Obv. the banks are interested in better ratings. In theory, the rating agencies are interested in protecting their reputation for impartial ratings and doing a good job and all that. But they are also interested in money. Who's to say if you start rating a bank's mortgage securities too harshly they won't stop coming to you? Maybe they go to one of the other two rating agencies and you're left out in the dark.

So there's an incentive to rate them quickly and highly. (An excellent article on the rating of the sub-prime bundles by Moody's appeared in the NY Time's Magazine a while back.)

Once the i-bank has the rating on the mortgage backed security, they skip merrily off to market them to whoever is interested in that rating of debt.

Which would be fine if these things had been properly rated and were made up of standard mortgages taken out by qualified people.

But why would there be mortgages taken out by unqualified people? And who would try to sell bundles of questionable mortgages? These, dear friend, are questions for the next segment...

(To fully understand the title of this post it may be necessary to listen to the song "Rape Me" by Nirvana and also understand how vile I find the role of the rating agencies in this whole mess.)