Three of the key actors in the tragic play that was the economic meltdown are the major credit rating agencies: Moody’s, Standard & Poors, and Fitch. First, we should establish that these organizations, despite being referred to as “agencies”, are not part of the government.
To appreciate the important role they play in the financial ecosystem, we must introduce a few other actors. Among the largest investors are “institutions”. These organizations have enormous sums of money to invest. A prime example is a state’s pension fund, an organization that manages a pile of money (which may be $100 billion or more) to pay the state’s employees when they retire.
To grow the amount of money in the fund and ensure that there will be enough to pay all the retirees for as long as they live, the managers invest the money. But, they want to do so carefully. After all, it’s retirement money they’ve been entrusted with. One way to invest money is to loan it out and collect interest. Some borrowers are more stable and creditworthy than others. What pension funds and other investors need is a way to distinguish between safe borrowers and ones that may not pay the money back.
This is where the credit rating agencies come in. They specialize in evaluating the creditworthiness of borrowers and assigning them a rating that is like a report card grade, from A to D. The idea is that the pension funds, with their mission to protect retiree funds, will only loan money to A-rated borrowers. Investors wanting to take greater risks can loan money to B or C-rated borrowers, collecting more interest.
Let’s talk about the housing market. The vast majority of people who buy a house have to borrow some of the purchase price. The loan they get from a bank is called a mortgage. The amount of any single mortgage, at one or two hundred thousand dollars, is not enough for an institution to be interested in. However, if we add hundreds of mortgages together, we start talking about real money. This is where another player, Wall Street, comes it. It bought large quantities of mortgages from banks. By giving them back the cash they’d lent out – along with some profit for making the loans – this allowed the banks to continue to do what they’re best at, provide more mortgages.
Why would anyone buy a mortgage? To receive the monthly payments the borrower will make. But, Wall Street didn’t hold onto most of the mortgages. Instead, it bundled them together and sought resell them. To give investors some idea of the risk they were looking at, the rating agencies would examine the borrowers and assign the bundle a grade. A rating of A meant that they were safe enough for pension funds to buy.
For a while, this well-oiled machine worked as intended, and housing was a major contributor to a booming economy. However, after just about all the creditworthy borrowers who wanted a mortgage had obtained one, there was only one way to keep the housing boom going: start loaning money to less-than-ideal borrowers. By less-than-ideal, we mean people without steady jobs or a solid track record of paying their bills. To get these borrowers to qualify, they were given “sub-prime” loans. An example of this type of loan starts off with a small monthly payment that the borrowers can handle. However, after a year or so, the party is over and the monthly payment rises significantly.
These sub-prime loans were bundled and resold, through Wall Street, like the prior bundles. They received the customary high rating. But, they were fundamentally more risky. After housing prices peaked and began falling, after the sub-prime loan payments rose as they were supposed to, the borrowers couldn’t pay and the loans went bad in huge amounts. These highly rated mortgages turned out to be a time bomb, causing investors world-wide losses totalling as much as $1 trillion. When pressed for an explanation, the unapologetic rating agencies couldn’t say much more than “we stand behind our methodology”. Grade: F.
Why is all this backstory worth discussing here? Because you’d think an embarrassing situation like this would cause the agencies to accept blame for their role in the crisis and do a little soul-searching to ensure that they’d play it straight and call it like it is. It doesn’t look like this is going to happen. Instead, they’re helping to grow the magnitude of the next crisis. What are we speaking of? The travesty that Treasuries, which are bonds issued by the Federal government when it borrows money, deserve the agencies’ highest available rating, AAA.
At $12 trillion and growing by about a $1 trillion a year over the next 8 years, the national debt is so big that its repayment is anything but assured. Yet, the rating agencies, again not up to doing their jobs, issue vague pronouncements that state the obvious. A sampling:
Sep. 17, 2008 – Following the $85 billion bailout of AIG, Standard & Poors’ John Chambers noted in a Reuters interview that the U.S. Federal Reserve “has weakened the fiscal profile of the United States.” Referring to what could have happened if the U.S. did not boldly move to bail out AIG, Chambers added, “Lack of a pro-active stance could have resulted in further financial stress and put pressure on the U.S. triple-A rating. There’s no God-given gift of a ‘AAA’ rating, and the U.S. has to earn it like everyone else.”
He went on to say, “The lobster is still in the ‘AAA’ pot and still moving. The heat is turning up, but the water is still ‘AAA’ stable.” Thanks for the imagery. Makes one want to head for the nearest Red Lobster.
Jan. 11, 2010 – Fitch affirms that Treasuries deserve a AAA rating, but says, “In the absence of measures to reduce the budget deficit over the next three-to-five years, government indebtedness will approach levels by the latter half of the decade that will bring pressure to bear on the US’ ‘AAA’ status.” Now that’s kicking the can down the road!
Feb. 3, 2010 – Moody’s issues the following: “Unless further measures are taken to reduce the budget deficit further or the economy rebounds more vigorously than expected, the federal financial picture as presented in the projections for the next decade will at some point put pressure on the triple A government bond rating.” Gee, do you think?
(update 1) March 16, 2010 – Moody’s states: “At the current elevated levels of debt, rising interest rates could quickly compound an already complicated debt equation, with more abrupt rating consequences a possibility.” Just what we need, another vague warning! To wrap up this update, consider that this announcement contained so much double-talk that the following headlines appeared in the news covering the announcement: US, UK top debt ratings safe for now, Moody’s says (appearing in Yahoo! News, courtesy of the Associated Press), and Moody’s: U.S., Britain debt ratings at risk (appearing in the Denver Post, also courtesy of the Associated Press). Hmmm. I wonder who’s right.
What’s the cost of the dithering we see above? When the debt of the U.S. Government finally receives the downgrades that were deserved years ago, the interest the Government will pay to continue owing the debt will rise. The downgrades and the increased borrowing costs will serve to wake up a slumbering public to the crisis we face. Perhaps, perhaps, they will demand that the government do what it must, including inflicting pain through spending cuts, to attempt putting the nation back on a sustainable track. The longer the agencies snooze, the more the public will be lulled into thinking that things aren’t so bad. Sadly, on the issue of U.S. Government debt, the bond rating agencies merit … another F.
Can you answer?
1. What are the names of the three major credit rating agencies?
2. What are institutions?
3. Identify one type of institution.
4. Where do banks get the money needed to continue issuing mortgages?
5. What do we call mortgages made to less-than-ideal borrowers?
6. In what ways are less-than-ideal borrowers different than “prime” borrowers?
7. What critical mistake did the credit rating agencies make that contributed to the credit crisis?
8. What impending crisis are the credit rating agencies contributing to by not taking a stand?