Wednesday, January 16, 2008

Really, AAA is good

Paying for groceries and gas on your credit card and not being able to zero balance at the end of the month because you are broke is tolerable if you know that the month is a particulary bad month and your income and cash flow will quickly improve. Paying for groceries with your credit card and incurring 17% effective interest because you have no other viable options available to you is very bad news. It is very easy to get into a debt service death spiral as your minimum monthly payments are overwhelmed by new expenditures and you quickly hit your credit limit.

This is the basic scenario that a AAA rated bond insurance company is facing now. MBIA is in trouble and recently they issued a special debt offering that under specific accounting rules they can treat as if it is an equity offering. Since they are on the hook for significant CDO and ABS obligations, and have taken some losses there, they needed to recapitalize, and do so quickly. However the interest on the bonds is now very similiar to credit card interest rates [h/t Calculated Risk]:

The notes, issued by the embattled bond insurer to shore up capital and preserve its crucial triple-A credit rating, fell 5 cents on the dollar to about 89.5 cents on Wednesday and are now yielding 17 percent, said Wayne Schmidt, senior portfolio manager at AXA Investment Management.

MBIA's notes yielded 14 percent when they were first sold on Jan. 11. A higher yield suggests that sellers of MBIA's notes in the secondary market are having to sweeten the deal to entice potential buyers.

Right now, I have access to cheaper debt via junk mail credit card offerings than MBIA with its AAA credit rating and yet MBIA still maintains its AAA rating.

Do these ratings really mean anything other than the fact that Fitch, S&P, and Moodys' are scared shitless of a systemic financial crisis if any of the bond insurers' are significantly downgraded to reflect their actual ability to access the credit markets? Do the ratings have predictive value, or are they mere ornamentation that tells investors and lendors little useful information?

Well, another AAA rated investment is in trouble. Orion Finance, a SIV, defaulted on its debt, which forced S&P to face reality:

Standard & Poor's on Wednesday cut its credit ratings on Orion Finance, a structured investment vehicle, after the fund defaulted on its obligations to pay off maturing commercial paper.

S&P lowered the fund's issuer credit rating to "D," for default, from "AAA," the top investment-grade rating. Orion's commercial paper and medium-term note ratings were also cut to "default."

Wow, Orion went from AAA, a great risk, only slightly more risky than holding US government debt to complete default and near total losses for the bond holders. The ratings agencies did a great job there [/snark].

So what is AAA worth --- right now not a whole lot. Some companies deserve to be rated very highly as their cash position is good, they have sufficient reserves, their debt to income rations are low, and their business model makes sense. Other companies are screwed and receiving market credit at credit card rates. Yet right now they are both AAA --- so why trust AAA if you don't know what that phrase actually means.

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