Vivek Kaul
The American government has filed a suit against the rating agency Standard And Poor’s (S&P) seeking $5 billion in damages. The suit filed by the Department of Justice alleges that the rating agency gave good ratings to bad mortgage securities to earn a handsome income.
In the United States a home loan is referred to as a mortgage.
Lets try and understand this in a little more detail. Starting in around 2002 American banks and other financial firms started giving out what came to be known as subprime home loans. The term ‘prime’ was used in reference to the best customers of the bank. And loans to such customers were prime loans.
In its strictest sense a subprime loan was defined as a loan given to an individual with a credit score below 620, who had no assets and was thus unlikely to qualify for a traditional home loan. A credit score was a number calculated on the basis of the borrower’s past record at paying bills and loans of all kinds, the length of his credit history, the kind of loans taken etc.
On the basis of the number the lender could get some sort of an idea of what sort of a risk he would enter into by lending to the borrower. That was the purported idea behind the credit score. In the normal scheme of things, a borrower categorised as “sub-prime” would not have got a loan.
But those were days when anybody and everyone got a loan. Banks did not keep subprime loans on their books. What they did was that they pooled these loans together and sold bonds against them. The interest paid on these bonds was lower than the interest the bank was charging on the home loan. The difference in interest was the money made by the bank. This process was referred to as securitisation.
The bonds were bought by investors of various kinds. When the borrowers of home loans paid interest on their loans that interest was pooled together and was used to pay interest to those investors who had bought these bonds. The same thing happened with the principal on the home loan that was repaid by the borrowers. It was pooled together and used to pay off the investors who had bought these bonds.
By doing this the bank did not maintain the risk of the home loan defaulting on its books. Also by securitising the subprime home loans the banks got back the money they had lent out as home loans immediately. This allowed them to give out fresh subprime home loans which they again securitised by issuing bonds and so the system worked. The difference in interest was the money made by the bank. The bank also charged a fee from investors for securitising bonds.
If the bank had kept the loan on their books for the entire duration of the home loan, as used to be the case earlier, they wouldn’t have been able to make fresh loans immediately. Also, they would have to carry the risk of default by the borrowers on the home loan on their books.
As far as investors were concerned they got to invest in a financial security which gave a better rate of return than government and most corporate bonds. But what made them really invest in the subprime bonds was the fact that they got very good ratings from rating agencies like S&P, Moody and Fitch. So here was a financial security which had a rating which was as good as the government bond or a corporate bond, but gave a higher rate of return.
What was ironical was that the subprime home loans bonds were given the best rating of AAA. Subprime loans were basically being given to people who would have not got loans in the normal scheme of things. The lending terms had become so easy that home loans could be made to someone with No Income, No Jobs, or assets for that matter (or NINJA loans for short).
The lenders also introduced a loan where the borrower could simply get a loan by stating his or her income. The lenders wouldn’t make any effort to verify it. These loans came to be referred to as liar loans. In 2006, 40% of all subprime loans were liar loans.
Given this, the risk of default on subprime home loans was very very high. And loans with a very high chance of default couldn’t be rated AAA, which is what was happening.
But why were the rating agencies rating subprime bonds which were backed by subprime loans most likely to be defaulted on handing out AAA ratings? For this we have to go back in history.
In fact, a major reason why subprime bonds were able to get AAA rating was because of something that happened way back in 1970. This was the year when Penn Central, the biggest railway company (or what Americans call a railroad) in the United States, went bankrupt due to sustained losses in its passenger as well as freight operations. This was an event that credit rating agencies were not able to foresee.
Till this point of time the rating agencies ran a subscription based service. Hence what the rating agency thought about a particular new bond was not known to the world at large but only to those who had the subscription service of the rating agency.
In response to the crisis the Securities and Exchange Commission (SEC) mandated that brokers holding onto bonds which were less than investment grade would be penalised. But this immediately raised the question that who would decide what ‘investment-grade’ was? So SEC created a new category of officially designated rating agencies. The rating firms Standard & Poor’s, Moody’s and Fitch, were designated to be the three officially designated rating agencies.
What the SEC was effectively saying was that what the rating agencies thought about a bond was too important to be restricted only to those who were willing to pay for their subscription service. Hence, every rating from then on was publicly available.
But the ratings agency was a business at the end of the day, they had to also make money. The question was who would pay them if their ratings were publicly available? So the SEC deemed that the company which was in the process of issuing a bond, should get itself rated from the rating agencies and pay them for it as well.
This created a clear conflict of interest. The rating agencies could be easily played off against one another. And this is what happened during the entire subprime boom.
Banks and other financial institutions looking to rate their subprime bonds played off one rating agency against the other. If they did not get the AAA rating they were looking for their bonds they threatened to take their business elsewhere.
What did not help was the fact that the money the rating agencies made on rating subprime bonds was three times the money they made on rating other standard corporate bonds. This resulted in a lot of subprime bonds being rated AAA.
While the bonds may have been rated AAA, the basic point was forgotten. No bonds could be better than the home loans that were outstanding against them. And the fact of the matter was that the subprime home loans were the worst of the lot.
Given this, it doesn’t make any sense on part of the American government to blame only Standard & Poor’s for what happened. The other two officially designated rating agencies Moody’s and Fitch are equally to be blamed. And so is the American government (through SEC) for persisting with a regulation which allowed issuers of bonds i.e. banks and other financial firms to shop for a rating.
The article originally appeared on www.firstpost.com on February 7, 2013.
(Vivek Kaul is a writer. He can be reached at [email protected])
Moody’s
Pranab Mukherjee does a Paulo Coelho
Vivek Kaul
The rating agency Standard and Poor’s(S&P) has warned that India could lose its investment grade credit rating. In a report titled Will India Be the First BRIC Fallen Angel?, the rating agency said “Slowing GDP growth and political roadblocks to economic policymaking could put India at risk of losing its investment-grade rating.”
The agency revised its outlook on India’s ‘BBB-‘ long-term sovereign credit rating to negative from stable. What this means is that India runs the risk of losing its investment grade credit rating and being rated as speculative or junk.
Let us try and understand what this really means for India.
What is investment grade?
In 1970, the Penn Railroad, the largest railroad in the United States, went bankrupt. This was something that the rating agencies did not foresee. One of the repercussions of this bankruptcy was that the Securities and Exchange Commission (SEC, the American equivalent of the Indian Sebi) decided to penalize brokers who held bonds of companies that were less than investment grade. But who would decide what was investment grade?
As Roger Lowenstein writes in an article titled Triple-A Failure “This prompted a question: investment grade according to whom? The SEC opted to create a new category of officially designated rating agencies, and grandfathered the big three – S&P, Moody’s and Fitch…Bank regulators issued similar rules for banks. Pension funds, mutual funds, insurance regulators followed…Many classes of investors were now forbidden to buy non investment-grade bonds at all”.
Every rating agency follows different ratings. The rating agency Moody’s has 21 different type of ratings of which the top 10 are deemed to be investment grade. The remaining 11 are deemed to be speculative by the rating agency and “junk” by the market.
S&P has 12 different level of ratings of which the top 5 are deemed to be investment grade. India’s rating is BBB-, which is the last rating in the ratings which are deemed to be investment grade. If India’s rating is downgraded, then the next rating is BB+. S&P defines it as a rating which is “considered highest speculative grade by market participants”. Hence BB+ is the first rating at the junk level. The ratings are essentially meant to be an estimate of probabilities. Hence, the bonds of a country which has a BB+ rating are expected to default more than the bonds of a country which has a BBB-rating, thus making them more risky.
What will be the impact if India gets downgraded?
One clear impact will be foreign investors who are not allowed to invest in non-investment grade securities staying away from India. This would mean that pension funds and other long term funds will stay away from India. It could also mean that for foreign investors who have investments in India exiting their positions and the stock market might go down in the days to come. This after the brief rally it has seen recently in expectation of an interest rate cut by the Reserve Bank of India.
The way foreign investors think about India is very important in deciding how well the Indian stock market performs. Since the beginning of the year foreign institutional investors have been net buyers (the difference between what they have bought and what they have sold) of stocks to the extent of Rs 34,551.33 crore. During the same period the domestic institutional investors have been net sellers of stocks to the extent of Rs 18,666.06 crore.
This buying by the foreign investors is the major reason behind the BSE Sensex, India’s premier stock market index, giving a return of 7.85% since the beginning of the year. The threat of downgrade to junk status obviously does not put India in a good light in the eyes of the foreign investors. Given this, the stock market is likely to go down, and bring down the overall economic confidence in the country as well. It would also mean that Indian corporates looking to raise money from abroad would have to pay a higher rate of interest.
The bond market in India will largely remain unaffected because it doesn’t have much foreign presence.
The Azhar Syndrome
But the threat of a downgrade by S&P according to me is a smaller worry than the Azhar syndrome. So what is the Azhar syndrome? The term was first used in a report of the name brought out by First Global more than three years back in March 2009. As the report pointed out: “The Azhar Syndrome is all about Azhar… the kid from the slums in Slumdog Millionaire. He flew to LA for the Oscars, slept on clean sheets in an air-conditioned hotel room, for the first time (and possibly the last time)…came to his Bombay slum home…and moaned to the press “It is so hot here, and the mosquitoes…I can’t sleep”. He is finished. A few nights in a clean hotel room, and the guy can’t adjust back to the reality of his slum existence.”
Like Azhar assumed that the “five-day” party that he had in Los Angeles would continue forever, so has the Congress Party led United Progressive Alliance (UPA assumed that all is well and the economic growth that India saw for the last few years will continue forever on its own. India enjoyed a GDP growth averaging 8.7% during 2004-2008 and 7.8% during 2009-2011.
Pranab Mukherjee, the finance minister, rejected the threat of the S&P downgrade. In a press release said that the Government is fully seized of the current situation and he is confident that there will be a turnaround in our growth prospects in the coming months. Mukherjee expects the Indian economy to grow by 7% in this financial year. “A reversal of interest rate cycle, weak crude prices and a normal monsoon were likely to improve the economic conditions and the slowdown would not be as sharp as widely feared, and that the economy would grow closer to 7 percent this fiscal,” Mukherjee told a conference of chief commissioners and directors general of Income Tax on June 11,2012.
The things that Mukjerhee expects will help India grow at 7% are things he has no control over. This is the Azhar syndrome, which has plagued the Congress party led UPA for a while now, at work. The confidence that come what may, economic growth will happen continue on its own. Mukherjee and the UPA seem to be big believers in what Paulo Cohelo wrote in the bestselling The Alchemist – A Fable About Following Your Dream “Here is one great truth on this planet: whoever you are, or whatever it is that you do, when you really want something, it’s because that desire originated in the soul of the universe. It’s your mission on earth… And, when you want something, all the universe conspires in helping you to achieve it.”
The world might conspire to give India its economic growth. Interest rates might fall. Oil prices might fall. And the country might have a normal monsoon. But this is no way of running a country.
And the assumption that economic growth will happen because Mukherjee and his ilk say that it will happen, is clearly worrying. As Ruchir Sharma writes in his recent boo k Breakout Nations – In Pursuit of the Next Economic Miracles: “India is already showing some of the warning signs of failed growth stories, including early-onset of confidence.”
To conclude
Hardly any constructive steps have been taken to revive economic growth which is falling. Just talking about growth does not create economic growth. The solutions to the economic problems currently facing India are simple and largely agreed upon by everyone who has an informed opinion on the issue. As the Economist put it in a recent article titled Farewell to Incredible India “The remedies, agreed on not just by foreign investors and liberal newspapers but also by Manmohan Singh’s government, are blindingly obvious. A combined budget deficit of nearly a tenth of GDP must be tamed, particularly by cutting wasteful fuel subsidies. India must reform tax and foreign-investment rules. It must speed up big industrial and infrastructure projects. It must confront corruption. None of these tasks is insurmountable. Most are supposedly government policy.”
But there isn’t much hope going around. As the S&P report explains: “The crux of the current political problem for economic liberalization is, in our view, the nature of leadership within the central government, not obstreperous allies or an unhelpful opposition. The Congress party is divided on economic policies. There is substantial opposition within the party to any serious liberalization of the economy. Moreover, paramount political power rests with the leader of the Congress party, Sonia Gandhi, who holds no Cabinet position, while the government is led by an unelected prime minister, Manmohan Singh, who lacks a political base of his own.”
(The article originally appeared at www.firstpost.com on June 6,2012. http://www.firstpost.com/economy/sp-downgrade-and-indias-return-to-slumdog-status-340605.html)
(Vivek Kaul is a writer and can be reached at [email protected])