Happy anniversary! It’s been ten years since the end of the Great Recession.
And darn it, we are doing it again. If you hold bonds in your investment portfolio, you should continue reading…
Whether you remember it well or not, life as we know it nearly came to an end in the Great Recession of 2008 and 2009. An awful lot of people lost their homes. More lost their jobs. Even more lost a great deal of money.
What caused it?
Well, there is a lot of blame to go around, but when the dust settled and the government investigated what happened, the credit rating agencies - particularly Moody’s and Standard and Poor’s - were definitely villains in the story. The Financial Crisis Inquiry Commission called the ratings agencies “key enablers of the financial meltdown.” The U.S. Senate Permanent Subcommittee on Investigations concluded: “Inaccurate AAA credit ratings introduced risk into the U.S. financial system and constituted a key cause of the financial crisis.” The Securities and Exchange Commission and the President’s Working Group on Financial Markets reached similar conclusions.
Eventually, Standard and Poor’s was fined $1.5 billion and Moody’s was fined $864 million.
The Problem and the SEC's Solution
The core problem is this: Because interest rates are lower for higher rated bonds, entities (e.g. governments, corporations, real estate firms) want to receive higher credit ratings to lower their interest costs and these entities are also the ones that pay the rating agencies for the ratings.
Because the rating agencies compete for business, the rating agencies are under competitive pressure to make ratings decisions that please the firms that pay them - thus they may rank the firm's debt with a higher grade than it deserves - in order to win the business. That helps to explain why, in 2006, of all the mortgage-backed securities that Moody’s rated AAA, 73% of them were downgraded to junk bond status 2-years later.
After the Great Recession, the SEC decided that a solution to the problem was to encourage more competition in the ratings business. While I am very much a believer in markets, I am not an idiot….and that was an idiotic suggestion. Having more competition INCREASES the conflict of interest because it puts the buyer in an even stronger position!
To see a real-life example of the problem, look to the Four Seasons Resort Maui at Wailea. In 2014, Morningstar was hired to rate the six slices – otherwise known as "tranches," in investment lingo – of the $350 million bond being offered by the hotel. Morningstar rated some of those slices as high as AAA, others as low as B, and the rest were somewhere in the middle. In 2017, the hotel refinanced its $469 million debt and used DBRS as one of two firms to rate the debt. DBRS had recently changed its standards for properties like the Four Seasons Resort Maui and – surprise, surprise – the debt was rated three spots higher on comparable slices as those rated by Morningstar three years earlier.
Does it surprise you to learn that DBRS’s market share doubled to 26% within a few months of that change? Does it further surprise you that Morningstar, a year later, amended its methodology for rating deals like that of the Four Seasons? Does it surprise you that when the Four Seasons had another bond offering in 2019 for $650 million, that Morningstar was chosen as one of the firms that rated its debt? Does it surprise you that Morningstar’s grades on some of that debt were as much as 2 grades higher than that given on similar slices when rated by DBRS in 2017?
In this case, competition works to create grade inflation. By the way, that does apply to colleges, too.
Conflicts of interest are a bear.
U.S. Mortgage Debt
As of 2019, mortgage debt in America is more than $15 trillion. $7 trillion of it is insured by government sponsored entities, 33% more than the Great Recession. That means there is more quasi-government-backed mortgage debt today than at any point in U.S. history.
Now, just because the government is guaranteeing more loans doesn’t mean those loans are to people who cannot make their mortgage payments, so what is the risk? To gauge that a bit, I researched the quality of the underwriting done by the banks. Today, by law, mortgage payments may not exceed 43% of an owner’s income and that is clearly a rule to help people, and the banking system itself, from getting in over their respective heads. Of course, there are always exceptions to rules. That 43% limit may be exceeded if the loan is guaranteed by the U.S. government sponsored agencies known as Fannie Mae and Freddie Mac.
You read that right. If the government guarantees the mortgage, the underwriting is more liberal, not more strict.
As you might have guessed, nearly 30% of the loans insured by Fannie Mae in 2018 were to people whose mortgage payments were more than 43% of their incomes. That is more than double the percentage of people that had loans of that nature in 2016. This is an example of crony capitalism. When banks can offer mortgages to people that quasi-U.S. government sponsored entities guarantee, with loan underwriting standards that are more liberal than the private market is permitted to offer, government has provided a way for banks to privatize profits and socialize potential losses at the expense of the U.S. taxpayer.
To my knowledge, banks are no longer offering NINJA loans (“no income, no job or assets” loans) and that is a good thing. Still, the trend is in underwriting quality is not good.
U.S. Business Debt
Business debt has grown by 60% since 2007, largely as a result of low interest rates. Debt owed by publicly traded U.S. companies is over $10 trillion. If you add the debt of small and medium sized enterprises, family businesses, and other business which are not listed in stock exchanges, total business debt is $15.5 trillion. That is 74% of U.S. GDP.
Are easing loan underwriting standards by banks helping to support this increase in business debt, too?
It appears so. Deloitte’s 2019 Bank Industry Outlook cites a July 2018 Senior Loan Officer Opinion Survey indicating a banking industry belief that lending standards on commercial and industrial loans have relaxed since 2005. Furthermore, the most recent OCC Semiannual Risk Perspective report highlights an ease in underwriting standards for commercial credit.
At a Florida conference on financial markets, Jerome Powell, head of the Federal Reserve, said the following: “Today everyone is talking about whether businesses are borrowing too much.” Views about the risks from rising corporate borrowing “range from ‘This is a return to the subprime-mortgage crisis’ to ‘Nothing to worry about here,’” said Mr. Powell. “At the moment, the truth is likely somewhere in the middle.” Mr. Powell said recent corporate borrowing behavior shared a few very broad parallels with the subprime-mortgage boom. Debt has hit new highs due in part to “aggressive underwriting” using financial vehicles that sell different pieces of debt to different investors. “Business debt has clearly reached a level that should give businesses and investors reason to pause and reflect,” he said.
What to Do
I’m repeating myself, but the conflict of interest problem is a bear. Frankly, I don’t see a way to eliminate it. I do believe regulators can tinker around the edges with policies like “rating analysts must rotate between companies” to avoid the “regulatory capture” problem of human relationships. Also, criminal penalties should be hanging over the heads of corporate executives to prevent them from engaging in unethical behavior.
Still, all of that is weak sauce relative to the core conflict that occurs when a company that wants the great rating is also the company paying for the rating. The rating agency business is an incredibly profitable business. Fees can be as high as $1M for a single deal and industry revenue is in the multi-billions of dollars. Moody's adjusted gross margin is in the mid-40% range.....which is HUGELY PROFITABLE. It is so easy to be tempted to look the other way when that kind of money is at stake.
It is reasonable to be concerned that this conflict of interest problem and its impact on agency assigned ratings, combined with years of more liberal loan underwriting standards, could have people buying bonds that are not as credit strong as investors think they are. If there is a downturn in the economy and if there is “grade inflation” in the credit rating assigned to a company, the value of the bonds could fall further than you would normally expect, once people lose faith in the credit agencies’ ratings [again].
Be aware and beware.
Let me know if I can be of help.
Bruce Wing is the president of Strategic Wealth, LLC, a Registered Investment Adviser located on the north side of Atlanta.
Entrepreneur, financial guy, husband and father of two great kids.