When Standard and Poor's downgraded the US debt rating from AAA to AA+, the timing of its announcement marked the first of many comparisons to 2008. By breaking the news after the closing bell on a Friday, S&P gave the markets a fitful weekend of waiting and learning details before passing judgments in the form of trades. Any news capable of spooking the market usually arrives late on a Friday, if its announcers can help it. The painful disclosures from Lehman Brothers and other financial institutions in the fall of 2008 also mostly surfaced after the closing bell on a Friday.
Since S&P's announcement, and the past week of tremendous volatility, there has been no lack of comparisons to that awful period nearly three years ago. One connection however, and its place in the roots of the 2008 crisis, has not received the focus it deserves. The current system of making and using ratings (not the agencies and their incentives, but the actual ratings themselves) is a dangerous source of risk that puts no small amount of the blame for the financial crisis with an overlooked candidate: the institutional investors who lost so much in the midst of it. These players were pension funds, mutual funds, and other groups left holding the bag when the bad assets became truly toxic.
THE THREE R's: RISK, RETURNS, AND RATINGS
Investing of any stripe, be it equities or bonds, China-sized or fun-sized, is essentially about balancing risk and return. High-risk investments need to have similarly high returns to attract buyers. Low-risk investments find themselves bidded down to low returns by the number of investors eager for a safe haven. Preferences for risk vary, as some types of investors want stable modest returns and others want big risky payouts, so the degrees of risk/return for investments vary across every tiny point along the spectrum.
Ratings on the other hand, measure risk as single buckets of one class or another. The letter grades go from AAA down to AA to A to BBB to BB to B, and so on through C, with some plus/minus indications along the way. Each bucket signifies a riskier and riskier underlying asset and the differences between each can be hugely important, as we saw last Friday with S&P. An even broader division is the line between "investment grade" and "junk" assets. While it varies somewhat across funds and ratings agencies, the line is generally placed at BBB. Assets called investment grade are BBB and up, while junk is BB and down.
In essence, the distinction is the B+ line of finance. For a student, moving that B+ to an A- was an effort of life-saving importance, but getting a B- to a B just wasn't quite as urgent. The investment grade / junk bond line has a similar magic to it where the firms that make and sell securities want desperately to keep their products at investment grade. The simple reason for this eagerness is literally trillions of dollars. Institutional investors like pension funds manage enormous sums of money and most often require that any assets they buy meet investment grade. What's more, the AAA benediction has a similarly spellbinding importance to huge swath of funds which either require or exclusively buy at that rating level.
A problem widely cited to be at the core of the financial crisis is the plain fact that ratings agencies are paid by the sellers of bonds rather than the buyers. In other words, agencies like S&P and Moody's earn their fees from the investment banks whose products they judge for sale. To continue with the school metaphor, it's as if students handed their teacher his/her salary once given their semester grades.
This clear conflict of interest is one of the main reasons that highly risky bundles of mortgages (CDOs) had the AAA stamp of creditworthiness on them for as long as they did. In 2006, the year before the mortgage crisis truly began to hit, the portion of subprime-mortgage-backed securities given the AAA stamp was an absurd 93%. This extreme example seems to illustrate that ratings agencies would lie or allow themselves to be lied to in order to do business. Important as this these agencies' financial incentives was in the crash of three years ago, an even finer point on the economics of ratings may spell the difference between stability and another 2008 in our near future.
FISHING THE LINE
If the risk/return level for each investment exists on the spectrum of color with its infinitely more specific hues, then ratings are the color wheel. There are only so many categories: Blue, Green, Yellow, Orange, and so on. But just as one man's turquoise is another man's aquamarine, so too is one Color not really just one color. All the investments in a single rating class, be it AAA or 'investment grade,' aren't all of the exact same risk/return level that the rating purports to signify. Said mathematically, risk is a continuous function whereas ratings are a discrete function.
As a result, investment banks (and the ratings agencies that judge their products) have the incentive to make sure their products are the riskiest assets in each given ratings bracket. Because higher risk means buyers (pension funds) demand higher return (lower price to the banks, so lower profit), the sellers want to make sure their products are just above any ratings line: safe enough to get in the bracket, but risky enough to turn a better profit.
This tactic reminds me of a practice called 'fishing the line.' When a certain part of the ocean is designated a marine reserve and the boats that usually earn their keep from those waters' fish face GPS limits they can't legally cross, the fishermen steam up and down along the line catching the spillover. Investment banks have incentive to do the same with the lines of ratings levels, and their relationship with ratings agencies only further facilitates that inclination.
This practice of essentially mislabeling the safety of investment products, as we saw in its worst form in 2008, can inject massive systemic risk into the economy. While the central problem in that crisis was that some products were called 'Safe' when they weren't, of perhaps even greater importance is the aggregate effect of calling assets only somewhat 'safer' than they truly are.
THE USUAL SUSPECTS
When it came time to take stock of the 2008 financial crisis and find who was to blame for it, there was no lack of potential culprits: mortgage originators who wrote the bad loans, investment banks that bundled them for sale, insurance institutions that sold swaps (CDSs) covering the bank assets, Fannie and Freddie for vacuuming up loans to juice the whole system, the government for failing to sufficiently regulate all these activities, and finally of course, the ratings agencies for rubber-stamping the bad assets as AAA. One group normally singled out as a victim however deserves its share of the blame: institutional investors.
Despite the trillions of dollars they manage, these investors aren't faceless Wall Street giants; they are your retirement funds, your kid's college tuition, or your rainy day money. Pension funds and mutual funds make up huge sums of investments, your investments. The institutions and people that manage them should take better care and use better methods than the ones they did in 2008 and continue to do now.
The reliance that institutional investors have on ratings to determine the riskiness of assets they buy makes an unfortunate amount sense from their perspective. Considering the relatively small number of professionals working at these firms and the immense array and complexity of the products they examine, pension and mutual funds often have to depend on broad rules to pick investments.
For basic human decision-making, rules may be useful and at the core of our nature, but they often have poor economic logic (see Richard Thaler). In the case of institutional investors, relying on sharp lines between levels of risk induces banks to 'fish the line' and mask the true riskiness of their products by bumping it just barely over the next highest bracket. The broader the line and the more important its division, the more risk is likely to enter the system. In particular, emphasis of 'investment grade' over 'junk' and AAA over all else are dangerous rules to live by. In over-relying on these divisions, institutional investors are at best naive and at worst inviting their own deception.
THE NEXT CRISIS
As 2008 demonstrated, not all costs in finance are borne privately. There are huge social costs in the systemic risks of Wall Street that don't show up on the firms' cost/benefit balance sheet, and risk analysis performed by institutional investors is a perfect case. The increased cost of doing more of the work themselves rather than relying on ratings agencies (or at least better scrutinizing the agencies' work) isn't competitive from their perspective and any increased fees to cover it doesn't make sense for their investors when social costs are economy-wide.
Nonetheless, investors should of course put their money with funds that don't cut corners and perhaps higher fees would on balance help more than hurt. Finding a fund that behaves differently is a tall order for the average pension-holder though, particularly because standard practice is simply standard practice. Echoes of Citi chief Chuck Prince's famous comments abound: "As long as the music is playing, you’ve got to get up and dance."
In that sense, the S&P downgrade may actually be a terribly good thing for the country. When the United States government, that longtime rock of AAA credit, loses its platinum designation because of the political climate, investors may think twice about the magical importance they apply to broad labels like AAA and 'investment grade.' Painful as that change may be right now, particularly in the current economic climate, breaking the spell will in the long run save us from ourselves.