Following up on his take on Bernanke, Roger Lowenstein has another must-read piece in this Sunday's issue of the New York Times magazine, called Triple-A failure. Its a full frontal assault on the Credit Rating Agencies in general and Moody's in particular, with devastating explanations of the whole toxic mess of AAA ratings, mortgage backed bonds, CDOs and the unholy nexus between mortgage lenders, investment banks and the credit rating agencies, which obfuscated the credit worthiness of individual mortgages and let loose a flood of easy money for subprime borrowers, thus setting up the foundation for the housing bubble. A few excerpts below.

The case they [Moody's] showed me, which they masked with the name “Subprime XYZ,” was a pool of 2,393 mortgages with a total face value of $430 million. This particular lender took the loans it made to a New York investment bank; the bank designed an investment vehicle and brought the package to Moody’s. Three-quarters of the borrowers had adjustable-rate mortgages, or ARMs. Since subprime borrowers cannot afford higher rates, they would need to refinance soon. This is a classic sign of a bubble — lending on the belief, or the hope, that new money will bail out the old.

The analyst wasn’t evaluating the mortgages but, rather, the bonds issued by the investment vehicle created to house them. A so-called special-purpose vehicle would purchase the mortgages. Thereafter, monthly payments from the homeowners would go to the S.P.V. The secret sauce is that the S.P.V. would float 12 classes of bonds, from triple-A to a lowly Ba1. The highest-rated bonds would have first priority on the cash received from mortgage holders until they were fully paid, then the next tier of bonds, then the next and so on. The bonds at the bottom of the pile got the highest interest rate, but if homeowners defaulted, they would absorb the first losses. - Triple-A Failure, Roger Lowenstein, New York Times Magazine, April 27th, 2008.

Read the entire article to understand how the responsibility for holding on to subprime loans was passed up the ladder, but the important point, and the focus of the article, is the blatant conflict of interest the credit ratings agencies faced when rating mortgage securities. The only way the investment banks stood to make a profit was by getting AAA ratings for packages with high interest risky mortgages. This allowed them to borrow at low interest rates while collecting a higher rate of interest from the mortgage loan owners. The subprime borrowers wanted the loans, the lenders didn't have to bear the responsibility so they didn't object, the investment banks suddenly had access to a geyser of low interest capital for leveraging their investments, so they colluded with the credit rating agencies, who were themselves getting paid handsomely for handing out triple-A ratings, and that's where the buck stops. Had it not been for this rating, the whole game would have been worthless.

Question is, will the credit rating agencies - Moody's, Fitch and S&P - get punished, or face any consequences? Regulators are breathing down their necks, and the agencies themselves are going in for in-house reforms and downgrading ratings every which way, but consequences? Not much chance, except for the fact that they'll have to come up with another 'business model' soon, since municipal bonds, which also happen to be AAA, are now lumped into the same category as these fradulent MBS. So the downgrades are affecting the interest rate that cities and counties are paying to municipal bond insurers like Ambac and MBIA, which means that tax payers are getting fined for what basically has nothing to do with them.

That's nothing new, but already states like California and New York are taking steps to seperate out municipal bonds from the rest of the morass, and pretty soon there won't be a viable business model left for investment banks to be able to lump together AAA bonds with subprime crap. Deleveraging is a nasty business and a lot of people have been hurt, and more will get hurt pretty bad. But at least we now know what the illness is. And make sure it doesn't happen again.