Thursday, January 8, 2009

Fixing Wall St. Part I

Many clueless Wall Streeters bought sub prime mortgage backed securities because the rating companies, Moody's and Standard and Poor's, gave them AAA ratings. Unfortunately, those AAA ratings had been paid for by the issuer of the securities. "Give my security a AAA rating or I will take my business, and your fee, elsewhere". Naturally the rating agencies issued a lot of AAA ratings that shouldn't have been issued. And even more clueless brokers bought trash on the strength of a AAA rating.
In real life, rating a security is fairly simple, and any real broker ought to do his own rating, just in case the agency rating is phoney. All you have to do is look at the borrower's cash flow and decide if his cash flow is large enough to pay off the security on time.
Ratings should be based upon cash flow, never upon collateral. In a collateral loan (like a car loan) the borrower pledges to turn over the collateral to the lender if he cannot pay off the loan. Problem with relying upon collateral, is that when times are bad, the value of the collateral falls, in extreme cases the collateral becomes unsalable (worthless).
Lender's should look at cash flow, is this borrower making enough money to pay off the loan. No cash flow, no loan.
And never again believe a rating agency.

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