Steer clear of the rotting bond market

Because, I'd argue, while bond-market professionals -- with a few exceptions, such as Bill Gross of Pimco, who publicly turned bearish in late spring -- have maintained a "what, me worry?" stance in public, they're actually now deeply worried about the structure of the bond market. And the closer they look, the more rot they see in the structure.

It's becoming increasingly clear to bond-market professionals that an unfortunately large percentage of their peers didn't have a clue what they were doing as they ramped up to take advantage of the boom in the market for corporate debt. In the United States, 2006 was a record year for corporate debt, with $1.05 trillion in corporate bonds issued, 40% above the level for 2005. The rest of the world kept pace: In China, 2006 set a record with $13 billion in corporate bonds issued and 2007 started out on a pace to double that total.

Wait! There's more

Corporate bonds were just the tip of the global-debt-market iceberg in 2006, however. The big action was in derivatives, packages based on bonds (derived from them, so to speak) that sliced and diced risk to lower corporate interest bills and to give investors, such as insurance companies and pension funds, investments tailored to exactly the risk and reward needs of their portfolios. Derivatives based on bonds and loans climbed by $15 trillion in 2006, a 100% increase over 2005, according to the Bank for International Settlements. (The total derivative market, which includes derivatives based on commodities, currencies and stocks, climbed to $415 trillion in 2006).

But did every bank or investment house that looked for a piece of the profit from this boom know what it was doing? Not a chance.

For example, Banca Italese, an Italian financial company that had specialized in asset-based lending, dove into the derivatives market in 2003. The bank started to offer fixed-rate financing, instead of its traditional floating rate deals, and used derivatives intended to offset fluctuations in interest rates. At the end of 2006, the bank reported, its exposure in the derivatives market was about $300 million. Not excessive, perhaps, for a bank with a market capitalization of $8.5 billion.

But Banca Italese never bothered to build a derivatives department devoted to analyzing the risk of its deals. Whoops. By the beginning of June, after euro interest rates had moved substantially higher, the bank's exposure had climbed to $800 million from the earlier $300 million estimate. The bank has spent $300 million to cap its interest-rate risk -- it hopes. And the bank's market capitalization has dropped to $2.9 billion from $8.5 billion in a little more than five months.

Bond professionals know that Banca Italese isn't alone. They know that most players in the derivative market aren't capable of accurately assessing the risks of these instruments. In fact, they're increasingly worried that even the big credit rating agencies like Moody's (MCO, news, msgs), Standard & Poor's and Fitch aren't up to the job.

The bond buddy system

It's important to understand that bond professionals don't want to think badly of the job done by the credit-rating agencies. The bankers pay the rating agencies' fees. (Bet you didn't know that. Yep, the issuers of debt are the ones who pay the bills.) The bankers literally sit across the table from the rating agencies. The banks poach anybody on the other side of the table that they think has the talent to work for them. And the banks rely on the credibility of the rating agencies to sell their debt offerings. It's a pretty cozy club.

But the subprime debacle has been big enough to disrupt the club. Buyers of packages of subprime mortgages and derivatives based on these packages that have been burnt by rising defaults on these mortgages and falling prices for the debt they hold have angrily wondered if banks issuing the debt disclosed all the risk. And the banks have passed the buck, saying, that they relied on the ratings from the three agencies.

Big problems with recently rated issues have turned up the heat on the agencies another notch. For example, as late as March 14, 2007, the day that the New York Stock Exchange delisted New Century Financial (NEWCQ, news, msgs), the second largest subprime mortgage lender in the United States, the ratings agencies had downgraded less than 1% of the subprime mortgage securities issued in 2006. Buyers were asking why the agencies hadn't moved faster -- and indeed, why they hadn't caught the problem when these mortgage-backed securities hit the market in the first place.

One possible answer is that the ratings agencies have become so entwined with the banks who issue the debt they're called upon to rate that they really aren't independent any longer. A study by Joshua Rosner, a consultant at investment research company Graham Fisher, and Joseph Mason, an associate professor of finance at Drexel University, argues that in the age of increasingly complex derivatives, debt rating agencies often actively work with debt underwriters to ensure that the different pieces, called tranches, of the offering are crafted to earn the necessary credit quality ratings to appeal to investors with different appetites for risk.

Why is that important? Because the agencies have become an active participant in structuring the deal so it will sell, the study concludes, which has compromised the agencies' independence. (If you see a similarity with the accounting profession in the era of the Enron scandal, you aren't alone, and the comparison scares some people on Wall Street silly.)

Numbers aren't adding up

You don't have to believe in collusion between debt underwriters and the ratings agencies, however, to worry that the system isn't working. The criticism here is coming from bond professionals who have produced a series of studies showing that pools of debt called CDOs (for collateralized debt obligations) aren't showing the patterns of return and default that their credit ratings predict. For example, one study shows that tranches of CDOs with the same BBB credit rating, which should trade at roughly similar prices, are instead trading at yields that differ by anywhere from 1.4 to 10 percentage points. At the A and BB levels, the gap is something like 4 percentage points. The U.S. Federal Reserve recently weighed in with a paper that said the ratings for CDOs are riddled with "anomalies."

Continued: There couldn't be a worse time

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