On Twitter and elsewhere there is constant
talk of the who is to blame for the mess we are in. The Tories blame Labour and
vice versa, everybody blames the bankers and occasionally it turns out to be
our fault.
What confuses me is that, whilst greed and
avarice were certainly big factors in what happened there is one over riding
principle that seems to have left everybodies consciousness.
If I apply for a loan or a mortgage the
people I go to turn to credit checking agencies to see if I’m a good bet. They
then look at my credit history; have I paid my way, have I got any CCJ’s, etc.
in general am I a good risk and they ‘score’ me for the financial house I’ve
gone to so they can make an informed decision.
Back in 2008 the banks were doing that with
the bonds and stocks they traded. Certainly they were playing some games that
were not right, messing with LIBOR and so on, but the main plank of what they
did was to buy and sell securities using credit ratings to decide how much risk
to take.
Two mighty organisations exist that gave
them that information, both American and both making shed loads of money
throughout the boom years – those companies are Moody’s, Fitch and Standard
& Poor’s (S&P).
From about 2003 these three goliaths had
given their AAA rating, normally reserved for a handful of the world’s most
solvent governments and best run businesses, to thousands of mortgage backed
securities. These ratings are specifically designed to predict default
percentages
S&P, for instance, told investors that
when they rated a particularly complex type of security known as a
collateralized debt obligation (CDO) as AAA there was a 0.12% likelihood – one
chance in 850 - that it would fail to
pay over the following 5 years. That made it as safe as a gilt edged corporate
bond and safer than S&P now rates US Treasury bonds.
In fact, around 28% of the AAA rated CDO’s
defaulted, that’s more than two hundred times higher that they predicted.
This is just about as complete a failure as
it is possible to make in a prediction: trillions of dollars in investments
that were rated as being almost completely safe instead turned out to be almost
completely worthless.
Prediction is all about experience. When
you don’t have it you should be cautious. The truth is the ratings agencies had
virtually no experience of these securities as they were new and very novel.
The ratings didn’t have any historical backing, they were just predictions
using a computer model.
So banks around the world, trusting the
ratings agencies did what they always do, they traded securities to increase
the banks profits and allow us to get cheap credit. Until it went wrong……..
So you would think that everybody would
have blamed these three agencies. But at the meeting of the House Oversight
Committee on 23 October 2008 that didn’t happen.
The ratings agencies sang with one voice.
They blamed the “housing bubble” and irresponsible US lenders, they said they
didn’t see it coming. The ‘housing bubble” phrase appears in just 8 news
accounts in 2001 but had jumped to 3,447 by 2005; it was discussed about 10
times a day in reputable newspapers and periodicals. Yet the agencies say they
missed it.
The ratings agency market is quite an
exclusive club. They are regulated by the US government and most pension funds
require their rating before they will buy anything. As a result their revenues
from giving out ratings exploded. Moody’s revenue from this market increased
800% between 1997 and 2007 and became the majority of their business. Their
cozy relationship meant they had little incentive to compete on ratings
accuracy nor to put too much effort into it. The agencies were paid by the
issuer of the CDO everytime they rated one, even worse S&P gave copies of
their ratings software to issuers so that they could manually calculate how
many ‘bad’ mortgages they could add to a bundle before it went down from AAA.
By taking risk models and finding a
mathematical way to include uncertainty into the model the agencies took highly
novel securities and bundled huge amounts of systematic uncertainty into them,
claiming the ability to quantify it; this was utter nonsense.
The end result was that the market lost
confidence in these securities before the ratings agencies and the collapse
that followed was uncontrollable. On the very day of the crash these agencies
were still rating CDO’s at AAA.
Yet we saw no high profile resignations, no
class actions by the banks and virtually nothing from governments anywhere in the
world. It was if the engineers of this crisis got away scott free.
I make no comments about why that was, I’m
as confused as the next man, but it just seems odd that’s all…….
