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 preset 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?

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.