Blame Everyone. Accept No Blame.

I find this almost funny at this point; comical, really. Moody's, who suggested that their triple-A ratings collateralized-debt obligations (CDOs) may have been incorrectly assigned due to a computer error is now ousting some employees along with an announcement that some may have violated internal policies to award unwarranted investment-grade ratings on constant-proportion debt obligations (CPDOs). Moody's has suffered a substantial hit to its credibility, to be sure, but do such tactics really work to reverse public opinion?

The media holds a very influential position in that it is often able to sway opinions in the general public. In this case, however, you're talking about a very specialized group with an intimate understanding of the companies involved and the business of credit ratings. Does media rhetoric really affect the opinions of investors who understand enough to question Moody's credibility in the first place?

Timing Losses & Financial Institutional Strength

Let me tell you a story to prove a point. Assume that you loaned me $1,000 2-years ago (thanks, by the way) and I had not paid you any interest or principal ever since. Assume further that we met today to negotiate a settlement and I offered to pay you $200 as a one-time payment to satisfy the entire amount of the loan. The question: how much money did you lose and when did you lose it?

Those of you who are financial inclined are likely already doing some discounted cash flow calculations, but let's keep things simple; let's ignore the time-value of money. Many of you, then, are likely shouting a loss of $800 today, and I'm sure that many more of you would be tempted to agree, but to see why this is the wrong answer, we need to differentiate between paper-losses (accounting) and actual losses (cash flows).

From an accounting perspective, you, the lender, had created an account to represent the account loan and the expected future repayment. What is important to acknowledge, however, is that the $1,000 that you lent to me flowed out from your bank account 2-years ago - not today. Put differently, you have had $1,000 less funds for 2-years; my offer to repay you only $200 of the full amount does not represent a loss, but rather a positive cash flow today. Actually, it's as simple as:

-$1,000 :: cash flow out to me in the form of a loan

$0 :: cash flows from my repayment of principal and interest

+$200 :: cash flow from my repayment and settlement of the loan today

Now, I'm sure you're asking yourself why this revelation is important. Well, let's consider the banks that are scrambling for credit and new sources of financing in light of the so-called credit crisis spurred by the billions of dollars in write-downs. Ask yourself when those related losses actually occurred. Also, ask yourself whether the settlement of these debts at $0.20 on the dollar leaves more or less cash on the balance sheets of these banks. Notice, that I asked about whether this left more or less cash - I didn't ask about net assets. This is the difference between accounting losses and actual (cash flow) losses.

The interesting conclusion that many of you are now likely making is that the settlement of these bad debts is actually leaving these banks in a stronger, rather than weaker, financial position. So why are they scrambling to borrow from the Federal Reserves auction facilities? Good question. They certainly don't need the cash - their cash positions haven't changed! Only their accounting positions have changed. It is true that this does affect their ability to lend as it leaves them with fewer assets and collateral, but fears over bank failures is certainly unfounded. Now, as an investor watching the markets and seeing the tumbling stock prices of many, if not all, financial institutions, ask yourself if the broader market has misinterpreted the events over the past few months. Lastly, ask yourself the market's overreaction leaves you with an opportunity to profit from the rebound that is unquestionably going to happen - given enough time for the banks to restart their lending engines.

It Wasn't Us; It Was The Computers!

That's what Moody's appears to be saying, or at least laying the groundwork to say, in light of the many law suits that are waiting in the wings spurred by the collapse of so-called Aaa-rated securities. One of the biggest head-scratchers with the financial crisis has been how such high credit ratings could have been issued on securities that were so susceptible to default; with news that Moody's is now investigating a possible computer bug that caused the mismatched ratings, it certainly does look as though it's covering its proverbial ass.

Both Moody's and S&P only began to strip-away their previously issued triple-A ratings after some of the constant proportion debt obligations (CPDOs) defaulted. Are we to think, then, that S&P's rating system was inflicted by the same virus?

CPDOs are portfolios of index-based credit default swaps (CDSs) that include both risky and safer trenches that have, somehow, made them candidates for the highest investment grade ratings. These CPDOs represent the latest innovation in one of the largest markets - credit default swaps - allowing investors to collect even higher returns as a result of even higher leverage. From this short description alone, does it sound to you as though this would qualify as deserving a Aaa rating? When will investors learn that there's no free lunch; higher rates of return do necessarily mean higher assumed risk. Period.

Banks created at least $4 billion of CPDOs, promising annual interest of as much as 2 percentage points above money-market rates combined with the highest credit ratings -- described a ``holy grail'' for investors by Bear Stearns Cos. strategist Victor Consoli in a November conference call.

There's no holy grail; if there were, every investor, their brother, their sister and their cousin's nephew would be buying and the price of such assets would rise and thereby reduce its yield. It's a classic arbitrage opportunity that just can't exist for any extended period of time. If a broker or advisor is telling you differently, then they themselves probably don't understand the securities.

Here's a bit of a primer on CPDO's and credit default swaps from this bloomberg article:

CPDOs sell contracts on credit-default swap indexes and use the premiums to pay investors. If the perception of credit quality deteriorates, the cost of insuring the debt increases and CPDOs lose money. To make up for losses, the funds would typically increase their borrowing.

Credit-default swaps, contracts conceived to protect bondholders against default, pay the buyer face value in exchange for the underlying securities or the cash equivalent should a company fail to adhere to its debt agreements.

Rating a CPDO involves making assumptions about the way the indexes of credit-default swaps will move, based on a limited history of the benchmarks. The U.S. index referenced by CPDOs was created in 2003; its European counterpart started in 2004.