I
have previously written [1] about the impending
failure of US mortgage borrowers, whose failure to
pay would affect not only the US economy as many
of them declare bankruptcy, but also worldwide
markets, as the risk has been widely sold to
investors in other countries, with the bulk of the
losses coming in Asia.
Ratings,
securitization in brief Banks lend money to
a number of companies but, more importantly, to
millions of individuals. As banks themselves
borrow money from other
investors in the form of deposits and bonds, they
would like to sell down some assets. However,
anyone buying such assets from banks would be
naturally worried about the quality of assets, and
hence look to the banks to do two things: first,
hold enough of the risk (what is called "skin" in
the game) and, second, hire an independent
evaluator of these securities.
When a
number of similar receivables are packaged into a
bond, what happens is that anyone buying the bond
is dependent on the credit quality of people he or
she has never met. For that reason, the markets
depend on rating agencies such as Standard and
Poor's or Moody's, two of the largest companies
that perform such services and, coincidentally,
both of which are American. The third major rating
agency, Fitch, is European.
To a large
extent, investors depend on these ratings for
determining their investment appetite. Thus if you
walked into an Asian central bank and asked what
its criteria are for buying an asset, it might
reply that it holds securities rated above a
certain level, say double-A (the highest is
triple-A, the lowest is D - as in "Default"). [2]
However, there are two immediate problems
with this. First, ratings are paid for by the
people issuing the bonds mentioned above, not the
people buying them. Thus there is a logical
business reason for maintaining the rating at a
higher level than is strictly warranted by
fundamentals. This is called a conflict of
interest.
The second problem is that
ratings are merely opinions. It is a bit like a
film reviewer saying that the latest Bruce Willis
movie is fantastic, while it may well turn out to
be a stinker for most people. The difference, of
course, is that a bad film recommendation only
costs you US$10 (less if you buy a pirated disc in
Shenzhen), but a bad ratings opinion can cost you
millions. The agencies, while sophisticated, do
not know the future any more than the typical
astrologer. They therefore use masses of data to
justify their opinions, all the while employing
analysis of historical information.
This
is not the first time the rating agencies have
gotten it wrong in the markets. Whether it was
their wrong ratings of emerging-market countries
in the 1990s, or telecom companies earlier this
decade, and now securitization, the agencies have
been disastrously wrong on every new market.
Still, investors and regulators trust them to
provide judgment, as there are no alternatives.
The markets, though, always look ahead. In
other words, if an investor expects to receive
less interest on a particular bond, its price will
fall well before the interest actually falls. Thus
it is that markets are prone to overreact to
information, while ratings slowly catch up.
There are, however, a number of investors
- for example, central banks and pension funds -
that rely only on the rating agencies for their
information. Thus they fail to act when the
markets start moving, and are forced to act when
the rating agencies admit that the quality of the
bond is actually lower than was previously
thought. These investors are called "hogs" in the
market - they are fattened up and then
slaughtered.
Pay differential Of
course, it is also important to note a perverse
incentive structure that exists in all this.
Employees of investment banks are among the best
paid in the world, with specialists in
fast-growing areas such as derivatives commanding
seven- and eight-figure (US dollar) annual
salaries. In contrast, the people buying the risk
from them, such as Asian central bank workers, are
paid hardly more than $20,000-$50,000, with some
of the best ones paid more than $100,000. Only
Singaporean government employees are paid more
than their counterparts on Wall Street; this is a
subject I shall return to in a later article.
When such an incentive structure exists,
it is natural for many kinds of corruption to take
effect, including soft practices such as banks
paying for lavish dinners and ranging to more
contemptible practices such as bank-employed
agencies helping to pay for the tuition of
children of senior government officials in the
name of "marketing".
Meanwhile, it is also
important to note that there is no "crime" being
committed by those buying such securities from
investment banks, as they are required to invest
their countries' reserves in securities as defined
by a pre-set policy. Thus no one takes eventual
responsibility for losses on investment accounts,
especially in many Asian countries where
foreign-exchange reserves are a matter of national
security, and leaks about holdings, profits or
losses are punishable by long jail sentences or
worse. [3]
This week What
happened this week was a result of the prices of
mortgage securities falling sharply in the past
few weeks. Finally on Wednesday, the rating
agencies moved to cut ratings of more than $12
billion worth of bonds. This forced the "hogs"
mentioned above to sell their bonds into a market
that was already nervous about further weakness in
the US economy.
The result was, of course,
carnage. Being unable to sell all the securities
they had, many of the investors had to sell other
securities, including corporate bonds hitherto
unaffected by the rating moves.
The
immediate question arising from the rating
agencies' action focuses on timing. Why did they
downgrade this week, based on information that had
been available since February? The reason, of
course, goes back to the conflict of interest - if
agencies admitted that their ratings criteria were
wrong, they would lose a lot of business. Indeed,
financial newspapers have been pointing out over
the past few weeks that smart investors such as
hedge funds have been "short" the stock of rating
agencies (or their holding companies) for
precisely this reason.
As alluded to
above, we can see that the extra time gave the big
investment banks the opportunity to get rid of
their existing positions, most often to big
central banks around the world. We will know how
much these banks lost, especially in Asia, only
over the next few years rather than weeks.
Next steps The subprime banana
skin has thus claimed a number of victims,
including Asian central banks that are forced to
hold billions in US dollar securities because of
their currency manipulation that pushes up
reserves. It almost seems poetic justice that the
manipulators are given losses by the very people
they think they are helping, namely over-consuming
Americans.
I believe that forced
liquidation of many portfolios in Asia will create
further losses, but American borrowers will emerge
in essence unscathed from all this. Holders of
mortgage securities do not have any claim on the
underlying assets, only on the intermediate
companies, which will of course declare
bankruptcy, thus leaving empty shells for lenders
to pursue. Unlike in previous crises such as that
involving the telecom sector in 2002, most of the
losses will be absorbed by central banks around
the world rather than North American or European
commercial and investment banks.
This is
one of the greatest robberies of our time, and it
will go unreported in essence. Hard-working Asian
savers will see their central banks post billions
of dollars in losses on the US mortgage crisis in
the next few years, but nothing can be done about
it given the general lack of accountability across
Asia.
A more defensible long-term strategy
for these central banks is to cut their reserve
holdings by floating their currencies against the
US dollar and invest in their own countries
instead of in some distant delinquent borrower.
What I wrote in the "scalded cats" [4] argument
remains valid - Asians simply do not hold their
governments and central banks accountable for
performance. This allows all kinds of excesses to
be permeated on savings in the name of national
policy.
With more than $3 trillion in such
reserves being invested (wasted) on low-return US
and European securities just across Asia, perhaps
it is time for citizens to raise the question with
their central banks: Just whom are you working
for, your citizens or American homeowners?
Notes 1. Hobson's choice, Asia
Times Online, March 10. 2. Wikipedia entry on
ratings. 3. Examples
of most secretive central banks invariably include
all the major Asian countries, with no central
bank other than Hong Kong submitting accounts for
public inspection. 4. Asia's scalded cats, ATol,
July 7.
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