Poor standards

Aug. 14, 2011

Poor Standards

So, now we’ve been “downgraded” by the estimable Standard and Poor’s
(S&P). We’ve fallen from a top-of-the-line AAA rating to AA+. No one is
certain exactly how far the ripples from this will extend. The giant
mortgage houses known as Freddie Mac (Federal Home Mortgage Association)
and Fannie Mae (Federal National Mortgage Association) have already been
similarly downgraded.
The rating system is supposedly designed to help lenders understand the
credit-worthiness of potential borrowers and for borrowers to receive a
kind of credit score.
The coveted AAA rating simply means the recipient is a solid, stable
country or corporation that fully pays its debt and is likely to do so in
the future.
For corporations, the AAA rating means they can more easily borrow and
that their stock is a safe investment. For a country, it means they can
more easily borrow and have little trouble selling government bonds and
treasury notes.
Standard & Poor’s is one of three rating services (the other two being
Moody’s and Fitch’s, neither of which have similarly downgraded our rating
from AAA). It was started in 1860 by Henry Poor as a service to analyze
the financial condition of railroads. They eventually merged with the
Standard Statistics Bureau, becoming Standard & Poor’s. They were gobbled
up by international publishing and financial information giant McGraw-Hill
in 1966.
So why does anybody care what Standard & Poor’s thinks? Good question.
The theory is there has to be some sort of “independent” guideline for
lenders. S&P has become the leader because of their enormous size and
media savvy. They’ve essentially created the metrics they use to
determine credit-worthiness.
The problem is there is just no way to judge their judgment. The ratings
are opinions based on several factors, many of which are almost entirely
subjective. S&P doesn’t like our current political environment and
suggests the problems are untenable. They don’t think there will be
enough deficit reduction in the next two years and were nice enough to
give us a figure to shoot for.
Some might consider that meddling where they best not. Others have
suggested they are just doing their jobs. Either way, they’re speculating
based on the anticipation of congressional behavior, a fool’s mission in
the extreme.
It’s also troubling to many that on the corporate side, the rating
agencies are paid by the companies they rate.
There is no evidence of overt quid pro quo, payments in exchange for high
ratings. At the same time, all three are top heavy with well-rated
companies. And there is a danger of a kind of osmotic corruption. Even
the most honest analysts must be at least subconsciously aware they’re
looking at a company that may have paid them a great deal of money. If
the rating is poor there is really no point in that company repeating the
process, or the payments, in the years to come.
There is also a question of accuracy. The ratings services pretty much
missed the tech bubble bursting in the late ‘90s and then completely
botched, and in fact helped contribute to, the housing crash that started
in 2007.
As you likely recall, the housing market was a spreading brushfire in the
first few years of this century. More and more people with lower and
lower credit were buying in a housing market that was nearing the peak of
runaway prices. Lending institutions were handing out sub-prime and
adjustable rate mortgages like they were free samples at a trade show.
Some bright folks at the London offices of Goldman Sachs thought it
would be a swell idea to figure out a way to bundle thousands of the
high-risk mortgages into investment instruments that weren’t really
insurance or stocks or securities so they couldn’t really be regulated
by anybody.
Other branches of Goldman Sachs and other investment houses thought
this was a swell idea, too. Banks, insurance companies, pension funds
and others invested in these collateralized debt obligations (CDO).
Things were going just swimmingly until the economy started to stagnate.
Homeowners, especially those who obtained sub-prime mortgages at or near
the zenith of the pricing frenzy, began to default on their loans and the
bundled investment packages crashed. Billions were lost.
This is significant because S&P gave those CDOs the ballyhooed AAA rating
despite the fact that any return on investment was dependent on people
that, at least statistically, were significantly more likely to default.
That rating encouraged even more investment in what was a doomed product.
The high-risk CDOs received the AAA rating. The United States, which
hasn’t defaulted on external debt in 221 years or internal debt in 78, is
downgraded to AA+. The logical conclusion is that Standard & Poor’s uses
poor standards.
No poorer, however, than the celebratory reaction of some Republicans to
the news of the downgrade. They just couldn’t be happier.
Sarah Palin spewed out a delighted “I told you so” and suggested we should
have been listening to her. Other Republican presidential wannabes
followed suit. There were additional rhetorical smiles as the stock
market tanked. None of them have their own specific plan but, hey, if it
hurts Obama they figure it’s good for them.
The rest of us don’t really factor into the equation.
It is not especially encouraging that a rating service and some
politicians have become gleeful fellow travelers on what has seemed like a
long downward economic spiral. Even less so given that Standard & Poor’s
seems intent on contributing to a continued downturn and some folks who
want to be president seem to be hoping for it.