Something is wrong when an entire industry teeters on the brink of destruction because of - what? - a change in credit rating. Consider the anxiety in and around the monoline insurers. The recent MBIA situation simply brought the point home: investors have given rating agencies too much power. Way, way too much power. Somehow, someway, large swaths of the investor landscape has effectively abrogated responsibility for conducting proper due diligence because an entity which, by the way, is paid for by the issuer, has said "this instrument is ok for investment if your risk tolerance is (choose your letter)." What is happening today isn't unique - we've seen big, discontinuous changes in ratings when a rating agency just got it wrong, was late in incorporating new information, or simply followed the implicit guidance of bond market prices to reassess a ratings stance. And yes, I understand that bond prices and credit risks are not perfectly correlated, and that rating agencies are all about credit risk. But rating agencies remind me a lot of classic sell-side research: take a stance based on the historical information, and only adjust that stance when new information has already caused prices to move. This is not the way it should be. And the markets and investors well-being are in jeopardy because of an excessive reliance on third-party credit ratings.
The very premise of monoline insurers like MBIA and AMBAC has been in question for more than a decade. Minimal capital, massive theoretical exposure, little data on historical losses. It is the classic business of selling out-of-the-money put options, collecting premium, showing great ROE and margins until, POW! You're dead. One of my better posts as a blogger that maybe 3 people read is titled Volatility Management in a Complacent World. The date: April 15th, 2007. World looks pretty different now, huh? It addresses this exact issue, as do about 50 of my other posts about the properties of hedge fund returns, employee incentive programs, and many other financial strategies. So as risks were mounting across many of the instruments backstopped by the monolines, did they alter their strategies, buy insurance, seek to offset a measure of this long-tail exposure? Not really.
