US Sub-prime: A case in misplaced accountability...

The recent heavy numbers of defaults in the US sub-prime mortgage segment means that the banks giving out these loans will lose billions of dollars. This has done two things…

First, it has reduced liquidity in the global economy, sparking recessionary fears. The US Federal Reserve and the European Central Bank (ECB) have tried to respond by infusing billions of dollars in the world economy, thereby increasing Money Supply.

Second, other forms of investments, in particular equities in emerging markets now have an elevated risk profile. Indeed, all forms of capital are more risky. In part, this has caused heavy losses in stock markets around the world.

Economic fundamentals remain strong otherwise, but the length of this downtrend is difficult to predict as we may yet see the worst of these defaults.

In all the analysis and commentary, there hasn't been enough focus on what has been a critical enabler for the entire mess. The fact that many of these sub-prime mortgages were rated AAA by major credit rating agencies – an indication that the bonds were safe.

The fact that the fees of these credit rating agencies are paid by the very banks whose bonds are being assessed creates a clear conflict of interest and remains an issue that will probably not be resolved in the near future.

The situation is very similar to what happened in the late-90s/early 00’s when major auditing firms signed off on the financial statements of corporations without question since the fees of auditing firms were paid by the very corporations being audited. Think Enron-Arthur Andersen.

One day, we will learn...