Watching members of the Sell-Side ratings community downgrading whole classes of collateralized debt obligations ("CDOs") and their like from the world of derivative securities, we cannot help but be struck by the enormous conflict of interest on display -- between the rating agencies and the Sell Side firms, and the brokers and their clients -- so far without any comment from the SEC or the Congress.

Perhaps it's just time to say that any rating agency paid by an issuer is part of the "Sell Side."

In creating the CDO, the bulge bracket Sell Side firms paid the major ratings agencies a fee to assign a credit rating on these de novo special purposes entities or SPEs. You may recall this troublesome acronym from the Enron story. Now default rates on the underlying subprime mortgage collateral -- indeed, all mortgage collateral -- have risen -- but hardly enough to warrant a significant change in a credit rating -- unless that rating describes more than credit risk.

These supposedly "investment grade" SPEs, don't forget, were created by the broker dealer and in theory structured to withstand a wide fluctuation in interest rates and economic conditions, thus the rating. So what's changed?

Well, the yield spreads on CDOs certainly have blown out, several hundreds of basis points in many cases, if you can find a bid at all. But does this manifest change in investor perception really justify a change in credit rating ? If so, we're afraid to ask what CDO PDs will look like this time next year!

The shift in credit spreads has impacted CDO liquidity and thus collateral values, as the quotation by the New York Post illustrates, but again we ask: have credit default rates on CDO collateral risen enough to justify a change in credit rating in the unlucky CDOs? The unlucky investors in those two dead hedge funds sponsored by Bear Stearns & Co. (NYSE:BSC) may have been wiped out, but have the the CDOs owned by the funds experienced 100% defaults on the underlying collateral?

Does not look that way from here. Or maybe what the ratings community is really suggesting is that many of these CDOs and similar types of derivative securities should never have been assigned a credit rating by a Nationally Recognized Statistical Ratings Organization or NRSRO in the first place.

To the question, "is any CDO an investment grade vehicle," brings to mind a letter to the editor of the Financial Times. Todd R. Bault, Senior Analyst, Non-Life Insurance, at Sanford C. Bernstein committed a capital offense by speaking truth in public, namely suggesting that investor expectations of liquidity regarding CDOs are unreasonable -- if not irrational.

Rebuffing an FT comment suggesting that the CDO market need somehow be fixed by the Platonic guardians in the regulatory community, Bault wrote: "What if you are wrong? The collateralized debt obligations market strongly resembles reinsurance, where each additional layer of structuring adds opaqueness. This is a feature of the process and cannot be removed easily. This is why securitization of insurance has been stubbornly slow. More capital options have opened up, but liquid insurance markets still seem very distant and may be impossible for many lines of business."

Bault continues: "So what if the real answer is exactly what the CDO traders don't want to hear - use less leverage and back the deals with more capital? This is how one deals with the lack of liquidity in insurance and reinsurance. Your own columnists noted ("Does it all add up?", June 28) that CDOs 'are designed to be held until they mature', not traded in liquid markets. It may not be as sexy, but it works."

CDOs without leverage may seem like cake without icing to many Buy Siders, but Bault is right. The duration and credit risk profile of a CDO is made for insurance companies and traditional cash investors, hopefully investors who understand the underlying assets. Indeed, the big players in the insurance and loan servicing sectors would skip the CDO and just buy the collateral, cutting the Sell Side middle men out entirely. Complex Structured Financial Transactions involving CDOs, you see, were always targeted for "retail" chumps among institutional investors.

So again, we ask: if the CDO ratings downgrades announced by Moody's (NYSE:MCO) and Standard and Poors, a unit of McGraw Hill (NYSE:MHP), in the past several weeks really are a response to changes in investor perception, aka, "liquidity risk," then why were these structures ever rated investment grade in the first instance? Was the mere payment of a fee enough to convince the fine, highly skilled professionals at MCO and S&P to overlook the obvious defects in CDOs so nicely described by Bault?

But perhaps the rating agencies are concerned about credit risk after all. One reader commented on our July 2, 2007 issue ("CDOs: Mark-to-Dealer), that the liquidity risk regarding CDOs and other derivative securities may only be the start.

"There's another little very uncomfortable wrinkle that everyone misses in their evaluation/analysis of the subprime portfolios -- missing original notes! Since the funds/pools didn't originate the loans and it's a bunch of kids who are putting these things together, the documentation has been horrendously sloppy. So sloppy that there are several Legal Aid groups who are stopping home foreclosures dead in their tracks. Indeed, one of the prime agencies that would submit requests to the court for replacement docs has now stopped doing so as it is beginning to realize it could be accreting huge liabilities."

Huge liabilities indeed. We've been worried about the operational risks incumbent in collateralized securities for many years. Bottom line is that whether you're talking about CDOs or traditional MBS, private underwriters frequently fail to record a change in the collateral lean on real estate or other assets when a loan is sold or repackaged, largely because hiring lawyers to perform such ministerial but crucial tasks cuts down on deal profits. Remember, it's all about the "yield to commission."

But now that the US seems to have reached a near-term peak in terms of real estate valuations, even on lovely Manhattan island, a whole new generation of banksters can discover the wonderful, local world of residential loan foreclosure. Our colleagues at Forbes wrote an interesting article on just this subject on June 18, 2007.

Just imagine a securities fraud litigation where the Plaintiffs can successfully allege that the "underwriters" of a CDO (including, naturally, the Sell Side rating agencies involved in structuring and pricing the deal) failed to adequately perfect the collateral lien on the underlying mortgages inside a CDO. The prospectus says "secured," but maybe not. We wonder: Did the ratings agencies, bankers and auditors of CDOs (yes, there is an auditor who blesses each deal) even bother to query the issue of collateral perfection?

And just imagine how two reasonably well-capitalized publishers like MCO and MHP are going to find the necessary resources to successfully defend against the tidal waves of civil securities fraud & ERISA claims headed for the Sell Side.

Once upon a time, the top-three NRSROs were seen as journalistic enterprises which could argue that an arm's length relationship with issuers accorded them security from fraud claims. But now that MCO and S&P, in particular, seem to have joined with the banksters in an unholy union to actually structure deals, it's probably time for investors to reconsider the risk ratings appropriate for these companies -- along with the ratings on their CDOs!

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