SUBPRIME FOLLIES….Fortune notes that a big factor in the recent success of the subprime lending market has been the ability to repackage subprime loans into clever little bundles of asset-backed securities that are then traded on the open market. But there’s more. An even bigger factor is the fact that these debt instruments (called collateralized debt obligations, or CDOs) have generally received investment grade ratings even if the mortgages underlying them were highly risky.

Read the whole piece if you want to understand the technical mechanisms involved, but the article suggests one reason why the rating agencies might have been a little too eager to play along with this game:

At Moody’s (the only one publicly traded), net income went from $159 million in 2000 to $705 million in 2006, in large part because of increases in fees from “structured finance,” the umbrella under which this mortgage alchemy falls.

The rating agencies say that they’ve reviewed their ratings and don’t plan to change them. But what if they do?

Janet Tavakoli, who runs Tavakoli Structured Finance, points out that AA-rated tranches of CDOs backed by subprime mortgage paper now yield far more than AA-rated debt backed by other assets — a sign that the market doesn’t trust the ratings. “No one believes the ratings have any value,” she says. Opined Grant’s Interest Rate Observer: “We are willing to bet that the agencies assigned too little weight to greed, ignorance, and soft criminality.”

All this has real-world implications. If the rating agencies do downgrade some of this paper, investors who can’t own non-investment-grade debt would be forced to sell in droves. The losses could affect the bottom line of an untold number of companies, including insurers and possibly even mutual funds.

And if CDOs stop purchasing mortgage paper, then a major source of liquidity will evaporate. That tightening of credit could affect the demand for homes, thereby turning the virtuous circle of recent years into a vicious one of falling home prices.

This is pretty similar to the way investment banks managed to keep the dotcom bubble alive for a couple of years too long in the 90s. Analysts at brokerage firms were supposed to be neutral in their recommendations — in theory, there was a “Chinese wall” between analysts and traders — but in fact the wall had long since broken down and there were tremendous pressures to oversell stocks their firms had an interest in. Unfortunately, it took a while for everyone to figure out that the analysts had become little more than carnival barkers, and that allowed the bubble to get wildly out of control.

Is it deja vu all over again? Are we a couple of years too late with the supposedly impartial rating agencies as well? Stay tuned.

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