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You Say Potato …

The following is excerpted from remarks by David Einhorn in October 2007:

Consider municipal bonds. According to S&P’s long-term data the 10 year default rate on an A rated municipal bond is 1%; while a corporate bond’s default rate is 1.8%; and a CDO’s is 2.7%. An A rated muni has the same chance of default as a AA/AA- rated corporate and a AA+ rated CDO. When municipal bonds default the expected recovery rate is 90% compared to 50% on corporates and CDOs.

I’d like to use a baseball analogy to demonstrate the ridiculousness of the above fact, but then I realized the same thing applies to player evaluations. So let’s think of the analogy thus – it is like you and the guy in the cubicle next to you each getting the same performance review from your boss, and the same raise, even though your neighbor darts out of work early for a drink once a week and gets less done than you. Back to the credit markets, this behavior would hypothetically produce a situation where you can take an A rated municipal security and put it into a series of CDOs and end up with an AAA rated instrument, even though the underlying instruments are identical in each case.

As Einhorn points out, this means that municipal bonds are much safer than their ratings imply (or structured ratings less safe than their ratings imply) and that cities, towns, states and other municipal entities (and the taxpayers that support them) are paying far too much for servicing their debts (lower rated securities must pay higher interest). In a nearly $3 trillion municipal bond market even small differences in interest rates cost taxpayers billions of dollars.

Why this behavior? Read his take. Some will inevitably point to this as yet another example of market excesses and the for-profit world feeding on an unsuspecting public. Perhaps, but the rating agencies are virtually insulated from competition, their operations are virtually opaque (e.g. no one is permitted to crunch the same data they do to come up with their ratings) and they are (in)famous for having operating margins in the 40%-50% range. Find me another industry with such high margins where there are not a zillion competitors chomping at the bit to get in. I am not saying that everything the rating agencies are doing is fraudulent, rather I am making the more innocuous point that these are the sorts of things that happen when (for whatever reason) competition is not prevalent in the marketplace.

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