Chemical Eye on Bond Ratings
I don’t pay much attention to the bond ratings in the P & S index, because I know that most of them are highly subjective. On the other hand, I had always assumed that the bond ratings in the S & P Index were completely objective. When I found out that they were bogus too, I could only wonder what will we call the dismal science now?
Like derivative financial contracts and credit default swaps, the previous paragraph was intended to be confusing. Sorry about that--but I’m pretty sure that I didn’t wipe out anyone’s 401(k).
In case you didn’t notice, I was trying to cleverly contrast chemistry and economics. You see, “P & S index” is a reference to the annual indices of articles that were published between 1976 and 1988 in the international chemistry journal “Phosphorus and Sulfur” (with the growing importance of semiconductors, it has since been renamed “Phosphorus, Sulfur and Silicon and the Related Elements ”). And “bond ratings” is my tongue-in-cheek way to acknowledge the frustrating fact that chemists have vocabularies that often are more reflective of which school of thought they subscribe to, than of the molecules they are trying to describe.
Whereas we all know what the S & P Index is. It is one of the reasons your 401(k) has taken a nosedive. At least that is how I interpret the congressional testimonies that were given by leaders of the major bond-rating agencies, including Standard and Poor’s, during a post-financial collapse grilling by the U. S. House Committee on Oversight and Government Reform last October.
It seems as though the financial markets were deregulated to the extent that there was overlap between the people developing the mathematical models needed to calculate the financial risk of a complexly structured financial contract, such as a mortgage-backed bond, and the people who were designing the complexly structured financial contracts.
In chemistry, when two atoms collide, and the formation of a new chemical bond is energetically favorable, the odds strongly favor the chemical reaction going forward. We can be very thankful that all chemical reactions, whether they occur in the atmosphere or in our blood cells, are highly regulated by so-called rate laws . For a given set of conditions, such as temperature and pressure, every reaction has its own rate constant, which only depends on the nature of the bonds to be made and/or broken. It is independent of the on-hand supply of reactants as well as the demand of products by a graduate student’s research supervisor.
In other words, somehow the molecules “know” what they’re doing, and they are not influenced by money or performance evaluations.
In economics, and in the modern financial services industry in particular, the situation seems to be almost the opposite. People are buying and selling bonds, many of which have become so complicated that nobody understands them, and people are definitely influenced by money and performance evaluations.
For this system to be functional, there must be a means of assigning a risk value to each financial product that cannot be manipulated. Whether it was intentional or not, the system failed catastrophically because bond ratings became grossly inflated.
There is a clear and unsurprising parallel to the phenomenon of grade inflation since university administrators started relying on student evaluations to judge teaching effectiveness. But I’ll leave that to another day.
In the meantime, I hope that trust and reliability, which cannot exist without highly regulated objectivity, will return to the financial markets. After all, there are a lot of college students who will be adversely affected by scarce or expensive credit. We would all be the losers if our education system was the next domino to fall.
I also have new reasons to be glad that I am a chemist. There has been exactly zero inflation in bond energies, and there are no Ponzi schemes in Erlenmeyer flasks.
hear the audio: http://www.publicbroadcasting.net/wmot/news.newsmain?action=article&ARTICLE_ID=1455833
If bond ratings were as straight-up as Wall Street itself, the credit crisis might have been averted.
morguefile.com