There has been a great deal of finger pointing about the US sub-prime mortgage crisis of 2007-2008. Alan Greenspan and the Federal Reserve kept interest rates too low for too long, stoking an asset price bubble and creating a leverage binge of epic proportions. Investment banks and mortgage originators, such as Countrywide and Ameriquest, wrote loans and churned mortgage backed securities without any concern for the underlying credit. Regulators turned a blind eye. And punters bought homes that they knew full well they couldn’t afford, in the hope that they would be able to flip it to someone else for a higher price.
Without the ratings agencies, however, I am convinced the crisis would not have been anywhere near as bad as it was. There would have been problems, no doubt. It wasn’t just the US housing sector binging on cheap credit. But AIG, once the world’s largest insurance company, Lehman and Merrill Lynch would still be around today if Moody’s and S&P hadn’t lost the plot.
Much has been made of the disconnect between lender and borrower in the US mortgage market. It’s true that the person making the loan didn’t care about the borrowers’ ability to pay because it wasn’t their money. By the time the loans were carved into residential mortgage backed securities, re-sliced into Collateralised Debt Obligations (CDOs) and CDO squareds, the person lending the money had no idea what they were lending against.
The only reason investors bought the securities, however, was because they had been stamped with a triple-A rating by Moody’s and S&P. That is, these securities were deemed safer than lending to the government of China. So investors bought the securities for minuscule yields and those minuscule yields fed the machine that generated hundreds of millions of dollars of fees and billions of dollars of loans to people who had no hope of paying them back.
You could argue that investors have an obligation to do their own work. But the fact is that a large part of the income investing world had come to depend on S&P and Moody’s to do the work for them. And they stuffed it up, big time. A triple-B rating and investors would probably be doing their own analysis, but triple-A? Losing money on something rated triple-A was simply unfathomable.
As to how ratings agencies got it so wrong, that much is easy. In the 1970s, both S&P and Moody’s switched their business model from subscription based to an issuer-pays model. They went from getting paid by the people who needed their research, to getting paid by people who needed a high rating.
What amazes me is not that this new business model created a massive conflict of interest, but that it took more than 30 years to rear its ugly head.
There were other crucial points in Moody’s evolution, such as 2000 when it became a listed entity in its own right (prior to that it was part of Dun & Bradstreet). Staff were given piles of options and, all of a sudden, their own net worth depended on the business’s profitability.
That first step down the slippery slope, though, was the important one. It wasn’t difficult to spot. All the Devils Are Here quotes a Moody’s executive in 1957: “We obviously cannot ask payment for rating a bond. To do so would attach a price to the process, and we could not escape the charge, that would undoubtedly come, that our ratings are for sale”.
Imagine you had sold your stock in 1975, on the basis that the business model was now so conflicted that it wasn’t going to be viable? And then watched the business grow from a sleepy little research company to one of the world’s most profitable businesses over the next 30 years?
It just goes to show that, not only can we be wrong, but we are often wrong for a very long time before we’re right. ANZ’s Asian expansion plans, for example, are well worth worrying about. Just don’t hold your breath.
Bethany McLean and Joe Nocera’s All the Devils Are Here provides great insight into the causes of the mortgage crisis and Roger Lowenstein’s Triple-A Failure article in the New York Times Magazine is a good summary of the ratings agencies’ fall from grace.
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Forager Funds is a boutique fund manager specialising in a value investing approach. We offer an ASX listed Australian Shares Fund as well as an International Shares Fund both aimed at delivering returns for long term investors.