Between Japan, Libya, and the Donald, I had nearly forgotten just how lousy and corrupt bond rating agencies are. Thank you S&P for lowering the U.S. credit outlook from stable to negative. By doing so, you reminded me of your existence and your existence reminds me that you and your cohorts have failed to predict any major financial catastrophe and essentially caused the 2008 financial crisis.
So while credit-rating agencies are back in the news, I'd like to take this opportunity to remind everyone of just how much they are in need of reform. Fitch, S&P, and Moody's account for 98 percent of the U.S. credit-rating market. Because issuers typically must receive two ratings, this means that the three firms have a virtual monopoly and regularly pull in 52 percent profit margins. In the early part of the 20th century credit, raters made money by charging investors who used the ratings to make investment decisions. This model meant that:
- The agencies were held accountable by investors who needed accurate information and would take their business elsewhere if the agency did a poor job and;
- Agencies had an incentive to provide the best possible information and had no inherent loyalty to any issuer. By the 1970s, this model had changed. Today, credit raters are paid by the very issuers whose debt they are rating. As if that clear conflict of interest wasn't bad enough, frequently the agencies will receive a second larger payment for providing an investment-grade rating. In short, the agencies have an incentive to provide the high ratings that their clients desire and are not punished by the marketplace at all for providing unreliable ratings.
So when push comes to shove, how have the rating agencies actually performed? Unsurprisingly, they've performed terribly. In the Enron collapse of 2001, all three agencies were giving Enron's debt investment-grade ratings until four days before the now reviled energy company filed for bankruptcy. Despite the increased scrutiny that came with this failure, the credit-rating agencies were even more negligent leading up to the mortgage crisis and credit collapse of 2008. They failed to downgrade Lehman Brothers' debt until the day they filed for bankruptcy. According to SEC Commissioner Kathleen Casey, "Ratings agencies just abjectly failed in serving the interests of investors." (Not that she was in a position to be throwing stones).
We know what happened during the lead up to the 2008 financial crisis. Banks bundled thousands of subprime mortgages into mortgage-backed securities. What you may not know is that these mortgage-backed securities were then stratified into layers with the best mortgages in the 'top' layers and the worst in the 'bottom.' Typically, the top layers of the securities would receive AAA, the highest possible rating. Lower layers would receive lower ratings and some were rated as junk. In retrospect, giving any of these subprime mortgages AAA ratings seems pretty foolish, but the next part of the story is even worse.
Unbelievably, banks would then strip out the junk mortgages, put them all together in a new pile consisting just of the junk, layer them into the best of the junk and the worst of the junk and submit this new junk pile to the ratings agencies. Guess what? The junk piles were rated in almost exactly the same way as the original pile with the top layers of junk getting AAA ratings!!! According to S&P, AAA means that "An obligor has extremely strong capacity to meet its financial commitments." Woops. Because these mortgage-backed securities received AAA ratings, they were included in the sorts of investments that your grandmother might make and priced accordingly as safe investments.
The AAA ratings for these mortgage backed bonds meant that they were included on balance sheets with virtually no detail, so that investors and even CEOs really had no idea of their exposure to these risky assets. These investments were treated essentially the same as U.S. Treasuries, as far as balance sheets go. Can you imagine? A balance sheet loaded with stratified toxic junk, given a rating agency stamp of approval and pedaled to the entire world as nearly as safe as U.S. Treasuries? Also, the high ratings gave loan originators a huge incentive to give mortgages to absolutely anyone that they could get in the door of their bank.
After all, no matter how junky the loan, it would end up being rated like a U.S. Treasury Bond.
In one instance cited in Michael Lewis' must-read book, The Big Short, an immigrant strawberry picker making $18,000 per year was given a mortgage for an $800,000 house. Loan originators would make the loan and then sell the resulting mortgage asset before they ever had to worry about whether the poor sucker they just lent to could possibly afford their monthly payments. When the credit raters finally realized that the house of cards was about to tumble, they went ahead and caused that tumble by downgrading AIG two to three grades. Well, the rest as they say is history. But, we must have learned from this experience right? Didn't we pass some financial reform legislation in 2010 to fix this problem?
The short answer is no. The credit rating agencies operate in nearly exactly the same way that they operated during the Enron collapse of 2001 and the financial crisis of 2008. The Dodd-Frank financial reform law did nothing to change the messed up incentive structure that has credit-raters receiving payment from the issuers they are rating. It did require increased liability for credit-raters that royally screw up. That seems at least like a step in the right direction.
The only problem is that this reform was suspended last summer after the ratings agencies threw a temper tantrum. In part, reforming the credit-rating agencies is difficult because (as you might be aware) the financial services industry spends massive amounts of money to ensure that things stay just the way that they like them. What could be better than paying credit-rating agencies to give you the rating that you want? But even beyond that, the rating agencies have been written into all sorts of financial legislation.
According to Frank Partnoy, former derivatives trader and professor at the San Diego School of Law, "Even though few people respect the credit raters, most continue to rely on them. We've become addicted to them like a drug, and we have to figure out a way to wean regulators and investors off of them." So far, we clearly haven't figured out how to do this. In fact, the three ratings agencies were relied on to help with sorting and cleaning up the mess resulting from the financial collapse of 2008. They profited from the very disaster that they helped cause!
So you'll forgive me if I don't engage in the collective freaking out which occurred upon S&P downgrading the U.S. outlook from stable to negative. I don't disagree with their analysis that the outlook for reasonable bipartisan cooperation in Congress on the deficit or anything else seems grim. We are talking about a group of people, after all, who can't even agree on what kind of cups to use in the congressional cafeteria. What I'm saying is that anyone who has been semi-conscious for the past year could have told you that members of Congress don't get along very well. The fact that S&P said it doesn't fundamentally change anything. It does, however, remind me of just how much credit rating agencies suck.