All of us would have at sometime heard the fairy tale – “The Emperor’s New Clothes”, the story of a little boy puncturing the pretensions of the emperor's court. We now have a sequel – The Subprime
Here is how the whole thing had worked –
Scene 1: Home loan borrowers with less than stellar credit were approved for a mortgage. The emperor (lenders) obviously wanted to get the monkey off his back and so invited the wise men – The investment agencies.
Scene 2: The rating agencies knew that the emperor was indeed naked. But may be they were willing to pull of an impressive story, for a fee. All of a sudden the risky consumer loans were reconstituted into something seemingly no more risky than a government Treasury bond and highest ratings were being issued. Of course like the wise men in the original fairy tale they too claimed that those who do not see these investments as safe were either stupid or not fit for their position.
Scene 3: Enter the investment banks. (I bet they knew clearly that the emperor was indeed naked). But why miss an investment opportunity, if the whole world is ready to believe that the emperor’s clothes’ are indeed magnificent, based on the claims of the wise men? Result – dress up these pigs into princess and sell them to the suitors.
Scene 4: It took a little boy to say that the emperor is indeed naked to actually wake up the world from its blissful slumber. Skeletons are being unearthed by the hour - allegations of predatory lending, misrepresentation and omissions related to the valuation of the loans and the profits from selling or servicing them, suitability of investments, breach of contract related to loan servicing, fraudulent conveyance issues, collusions with rating agencies…
It might be of interest to note that one of the wise men in our drama – Moody’s earned about $3 billion from rating structured deals from 2002 through 2006, and this area accounted for 44% of its 2006 revenues. Since the subprime fallout S&P has downgraded more than $ 12 Billion worth of these bonds and Moody’s has followed suit with downgrading more than $ 5 billion.
In one of the recent conference calls which this rating agency had with a hedge fund, the MD of the fund had a question:
I'd like to understand why you're making this move today and why you didn't do this many, many months ago."
It's a good question," responded the analyst.
"You need to have a better answer," said the MD.
