THE RATING FIRMS' MORAL HAZARD

A few people seemed to get that these firms had a conflict of interest when it came to collateralized debt obligations (CDOs).

Subprime Infects $300 Billion of Money Market Funds, Hikes Risk
By David Evans
Last Updated: August 20, 2007 00:18 EDT
Bloomberg

(excerpts)

Unbeknownst to most investors, some of the largest money market funds today are putting part of their cash into one of the riskiest debt investments in the world: collateralized debt obligations backed by subprime mortgage loans.

Under SEC rules, money market managers must invest in securities with ``minimal credit risks.'' Joseph Mason, a finance professor at Drexel University in Philadelphia and a former economist at the U.S. Treasury Department, says subprime debt in money market funds is far from safe.

Investors have sought safety during the subprime meltdown by moving their holdings to U.S. Treasuries and money market funds.

Credit rating companies don't just rate CDOs; they play an active role in assembling them, says Charles Calomiris, the Henry Kaufman professor of financial institutions at Columbia University in New York. Fitch, Moody's and S&P participate in every level of packaging a CDO, says Calomiris, who has worked as a consultant for UBS AG, Bank of America and Citigroup.

A CDO manager gathers hundreds of loan securitizations or bonds to use as collateral for the CDO. The debt supports an assortment of CDO sections, ranging from the riskiest non- investment grade to AAA or Aaa rated. CDO managers consult with analysts from the rating companies when creating a CDO, negotiating the highest credit ratings for each level, or tranche.

In the past three years, Fitch, Moody's and S&P have made more money from evaluating structured finance -- which includes CDOs and asset-backed securities -- than from rating anything else, including corporate or municipal bonds, according to their financial reports.

The companies charge as much as three times more to rate CDOs than to analyze bonds, their cost listings show. The three rating companies say these fees are higher because CDOs are so complex.

The close working relationships between CDO managers and rating companies -- and the fees that change hands -- mean money market funds shouldn't rely on ratings to evaluate CDOs, says Harvey Pitt, who was SEC chairman from 2001 to 2003.


Two money market funds run by AIM have gotten the message. They stopped buying CDO commercial paper. ``In today's market, you really can't trust any ratings,'' says Lu Ann Katz, AIM's director of cash management research. ... Katz says she's stopped buying CDO investments because she doesn't trust credit ratings and she thinks CDO paper in money market funds is too risky.