Almost 20 years ago, the famed Twin Towers were decimated by a series of aeroplanes that were hijacked and flown to crash into different strategic institutions across the US. For George Bush, having won a controversial election against Al Gore less than a year earlier, the attacks on American institutions would define his presidency.
In response to the public outrage, Bush and his team managed to convince themselves and particularly also UK prime minister Tony Blair that Saddam Hussein possessed weapons of mass destruction. That ruse — eventually proved to be a false conspiracy — led to the Iraq War with effects on Middle Eastern geopolitics that linger until today.
The true weapons of mass destruction were much closer to the US and had little to do with Saddam Hussein. In a speech in that interregnum between the 9/11 attacks and the invasion of Iraq, business tycoon Warren Buffett referred to financial derivatives as weapons of mass destruction.
They emerged in the late 1990s and became a permanent feature of global financial markets. Derivatives had become a key instrument driving the engine of capitalism. Their essence — captured in the name itself — is essentially financial structures that derive their value from other assets. In relation to the housing crisis, the instruments gave rise to the housing bubble. The housing boom that became the great gamble had a few interesting features.
Houses had long been regarded as a safe asset across the world. As the values of houses increased over time, a trend emerged that would enable house owners to compare the value of their house against the value of the loan they still owed on the house. In cases where the house value was higher than the loan value, a house owner could elect to access the value gap as actual cash.
The banks had little to lose as they would lend on the understanding that should anything go wrong, they would simply sell the house and get their money back. The model worked well as long as there were creditworthy clients to deal with. But as the pressures of competition intensified across the various role-players in the market — banks and bond originators, in particular — the question of who was creditworthy became a matter of opinion rather than fact.
At the heart of the conversation were the institutions that had the unique social and commercial license to offer opinions on the creditworthiness of prospective house owners — the ratings agencies.
Those clients deemed good enough — with a stable income, job security and good credit record — were indeed the prime steak of the market.
But this group could not grow infinitely. However, the appetite of the banks and originators to keep selling saw no end. As a result, the focus moved onto the next rung of clients below the prime-steak list — the sub-prime market, made up of those prospective homeowners who had more fragile credit standing, through irregular, inconsistent incomes, no other assets and lower job security.
The problem with lending anything to anyone whose ability to pay is suspect is that you run the risk of losing everything.
In the bottom end of the market — where incomes, jobs and assets occasionally did not exist, a newly coined term captured the nature of the market. Clients with “no income, no jobs and no assets” became known by the acronym Ninjas. Such a characterisation was the industry’s own acknowledgment regarding the risk associated with lending to prospective homeowners in this category.
But bizarrely, rather than using the red flag as a reason to decline loans, financial gurus sought to find creative ways to keep the market flowing despite the risk of clients whose classification was below prime.
A simple solution would be to mix up the portfolio of good clients with bad clients and treat them as one entity. Now you could sell the idea that if homeowner 1, with a good credit profile, was part of this portfolio, then it couldn’t be all that bad. Ratings agencies were responsible for providing an opinion on the creditworthiness of prospective clients. That assessment is relatively easy for a single company or a single homeowner. Once the financial engineers converted single credit applications to a portfolio, the ratings agencies’ abilities to tell the wood from the trees was severely diminished.
The trend emerged that portfolios made up of clients of different risk profiles, where a creditworthy client ended up in the same basket as a Ninja, were assessed through the prism of the strong clients and such portfolios were allocated the best ratings.
The casualty of this phenomenon was the reliance the market has always placed on the opinions of ratings agencies. As we have seen in relation to South Africa, a good rating from the main agencies — Fitch, Moody’s and Standard & Poor’s — is the golden standard that unlocks access to capital markets and investor appetite. A bad rating on the other hand — such as the junk status allocated to South Africa — has significant costs and consequences.
With this responsibility, one expected the ratings agencies to ensure that robust and rigorous assessments were the order of the day. The problem, however, is that no one is forced to obtain opinions from all ratings agencies. In some cases, a company needs only two main ratings agencies to offer an opinion before institutions such as pension funds can invest in it.
The way it all turned out, perhaps unsurprisingly, is that institutions that needed to be rated started shopping for ratings. If one agency provided an unfavourable rating, one simply sought an alternative opinion. But since fees associated with a rating are lucrative, the agencies themselves have a keen interest in keeping the mandate to offer the rating.
So, gradually and suddenly, bad companies and portfolios received good ratings, and ratings agencies generated record profits. As night follows day, the independence of the process was compromised — to the detriment of those who relied on the ratings to make decisions. And as the portfolios of assets packaged together in the form of derivatives became ever more complex, the ratings gurus found themselves rating all sorts of junk as investable. And as more market participants piled in to the sector on the back of these indisputable opinions, the very fabric of capitalism teetered on the brink of collapse.
In the aftermath of the crisis, questions were asked about the methodology of ratings and the nature of relationships they had with the clients they were rating. It became obvious that the ratings industry — with its preference for self-regulation — was a model that had long lost relevance.
During the US Senate hearings into the role of ratings agencies in fuelling the crisis, the agencies claimed that all they offered was nonbinding opinions and that everyone who acted on them was responsible for their own actions. This approach, self-serving and untrue in equal measure, became an illustration of capitalism’s failure to hold its primary role-players accountable.
Today, many years later, the trio of big ratings agencies continue to enjoy enormous power on global economics and global finance. Over the years, the limitations of their practices — from conflicts of interest, false ratings and political bias — have cost them millions in fines. Regrettably for society, the costs associated with the unchecked behaviours of ratings agencies — from the Asian financial crisis of 1997-8, the Enron scandal and more explicitly, the current financial crisis, are much greater for society.
Ratings agencies command the type of fees that allow them to withstand the impact of every fine imposed. A lesser-explored matter remains the cost to nations and individuals of ratings that go wrong and distort financial markets.
Back in 2008, the loss of global trade output in the aftermath of the crisis was almost 5% of global GDP. By contrast, the International Monetary Fund indicated this week that the loss in global output as a result of the coronavirus pandemic was 3.5% during 2020.
The fact that regulators across the globe have failed to come up with a solution to the ratings conundrum is either a reflection of priorities, or the seeds of the next crisis emanating from a regulatory vacuum are already being sown right in front of our eyes. The question may just be what form the next weapons of mass destruction will take.