The Rating Horrors and Capitalist "Efficiency"
by Rick Wolff
Many aspects of our "efficient" capitalism combined to produce the credit meltdown that now threatens ever more aspects of the global economy. One was the private rating companies' failure to accurately assess and honestly reveal the risks of securities based on a "bundle" of loans (securities that provide their owners with a portion of that bundle's principal and/or interest). This was especially true for securities based on mortgage loans issued in the go-go years of the housing boom. Investors around the world bought those securities based on those companies' ratings. Their purchases financed the US housing bubble now gone bust. We know now that those ratings were badly mistaken. Owners of those securities around the globe are taking staggering losses and reducing their lending to all borrowers. Anxiety about the risks of all sorts of borrowing has risen alongside deepening distrust of all risk assessments. Defaults, bankruptcies, and foreclosures rise together with the odds of recession in 2008.
Understanding why the rating companies contributed to this disaster opens a crucial window into today's global credit crisis. It also teaches basic lessons about today's globalized capitalism. Step one is to grasp the structure of the industry that sells assessments of the risks attached to securities (including those based on loans). Of the 150 rating enterprises around the world, three dominate. Moody's and Standard and Poor's -- the two industry giants -- have an 80 per cent market share. The US Justice Department refers quaintly to them as a "partner monopoly." Fitch has between 10 and 15 per cent, and all the others share what remains. This industry structure generates massive profits and profit rates at the top. Moody's, for example, generated 2006 revenues of $2 billion, from which it derived a pre-tax income of $1.1 billion (a better than 50 per cent profit rate). No wonder that Moody's top shareholder (a 19 per cent stake) is Warren Buffett. That wizard was wise enough to buy Moody's but not the securities that Moody's rated; then again his company, Berkshire-Hathaway, apparently held on to those shares as the credit disaster drove them down from over $70 to under $35 across 2007.
Step two is to see how badly those companies failed. Consider the research undertaken by Morgan Stanley and described in a recent (December 24, 2007) Barron's Magazine article. They studied the 6,431 subprime residential mortgage-backed securities issued in 2006. Of these, 2,087 issues were rated AAA (the highest rating, the lowest risk); 1,266 were rated AA; and the rest were rated A or lower. Within one year of being issued, most of these securities were re-examined by the rating companies as the values of such securities tumbled and it became clear that the rating process had missed something. As a result of their re-examination, over 50 per cent were downgraded, i.e. given a new, lower rating. Morgan Stanley compared the rate of downgrades in 2006-2007 to the historical norm for 1998- 2006. The results are stunning. Among AAA-rated subprime residential mortgage-backed securities, 4 per cent were downgraded (whereas the historical norm was 0.12 per cent). Among AA rated securities, 12.2 per cent were downgraded (versus an historical norm of 0.64 per cent). Of securities rated A and below, some 97 per cent experienced downgrades (versus the historical norm of 1.24 per cent.
Step three is to see the ramifications of so spectacular a failure. Across the world, all sorts of individuals, enterprises, governments, and non-governmental organizations (universities, charities, hospitals, etc.) purchased these securities to fund their activities. They now have to downgrade their activities to accommodate their now-downgraded investments, their lost billions. We have not yet begun to count the social costs of downgraded activities. Moreover, it is too soon to take a real count. All we can be sure of is that the losses are enormous. As risk aversion spreads, holders of other debt-backed securities lose more billions. Those with debts find it harder or impossible to turn over those debts. New borrowers face higher costs for smaller loans requiring higher down-payments. Economic activity shrinks. The US housing industry is thus already a disaster.
Some losses and some shrinkages have been announced. Many are yet unknown, uncounted, or else hidden because if known they would be politically explosive. For example, what losses on such securities would the Chinese government have to admit to its people? How will governors and mayors cope with US voters' anger at property tax increases required to compensate for looming difficulties in issuing bonds rated by the same, now-compromised rating companies? Which pension funds suffered losses from such securities that may prevent them from fully paying promised benefits? Which mutual funds purchased mortgage-backed securities and have yet to count or announce all the losses? Which of those mutual funds are included in the portfolios that your life depends on, directly or indirectly? What happens now that the companies who insure loans lack sufficient funds to pay the claims coming their way? Are the sub-prime credit card, student, and corporate loans that back many billions in other securities about to implode too?
During 2007, repeated scares about imported Chinese products (pet food, toys, etc.) taught us the lesson that the private profit motive can throw many toxic commodities onto global markets. The sub-prime mortgage scandals teach the lesson that the financial industries can spew even more toxic products onto global markets. The rating horrors teach that the profit motive can also infect the enterprises charged specifically with assessing the risk of those financial products. Along the way, huge profits have been made -- one side of the coin -- as huge numbers have been and will be fleeced -- the other side.
Ratings themselves were initially reforms. Years ago, when huge losses flowed from securities whose issuers had misrepresented their risks, the reformist demand arose that someone should "independently" assess their risk so investors would be honestly informed. It turns out now that providers of such independent assessments can misrepresent them as disastrously as their issuers did and do. Yet another set of such reforms -- and that is all the Barron's article cited above offers -- promises no better success than past reforms. Moreover, governmental "independent risk assessments" are as corruptible as their private enterprise counterparts.
The Barron's article uses the word "rotten" to describe the subprime mortgage crisis. Perhaps that word describes something deeper at work in our economic system that keeps regenerating booms and bubbles exhibiting irrational exuberance and gross financial hustles. At what point do the resulting vast economic and social losses require us to look deeper at more fundamental changes?
Rick Wolff is Professor of Economics at University of Massachusetts at Amherst. He is the author of many books and articles, including (with Stephen Resnick) Class Theory and History: Capitalism and Communism in the U.S.S.R. (Routledge, 2002) and (with Stephen Resnick) New Departures in Marxian Theory (Routledge, 2006). This article first appeared in Global MacroScope (at <www.globalmacroscope.com/>).