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Quis custodiet ipsos custodes? 🙄

Quis custodiet ipsos custodes? 🙄
By Making smalltalk • Issue #22 • View online

Note: image may be subject to copyright.
Note: image may be subject to copyright.
Subprime mortgages have a dubious distinction. If you search for or ask investors the cause of the 2008 Global Financial Crisis, the most common response you will find is that subprime mortgages triggered the financial meltdown.
(Subprime mortgages are basically poor-quality loans given to people who are unlikely to be able to repay it back. If you don’t know about the 2008 crisis, I strongly recommend you learn about it. There’s plenty on the Internet, including this Matt Damon narrated documentary called Inside Job)
But while subprime mortgages were certainly the asset-class whose collapse triggered the crisis, there are two other less-known aspects which really caused the financial crisis:
  1. The bonus-driven & short-term incentive structure at Wall Street
  2. Credit Rating Agencies like S&P & Moody’s, who rate bonds & mortgage products
Today we focus on #2 - the role of credit rating agencies.
Rating Agencies - Guardians of the (Fixed Income) Galaxy
Simply put, these are firms issue a rating that determines the ability of a borrower to pay timely principal/interest payments, and the likelihood of default. They are the guards of the fixed income world.
Based on their ratings, investors know whether a bond is “risky” (likely to default) or “safe” (will pay interest & principal). AAA is the highest rating, indicating that the borrower is highly unlikely to default.
Credit rating agencies don’t rate individuals - that’s the job of firms like CIBIL that maintain your “credit score”. Instead, these agencies rate bonds issued by Governments & corporates as well as various “structured products” like CDOs & CMOs that have a fixed-income/interest component.
If I’ve lost you here with these weird acronyms, here’s an excellent explanation from economist Richard Thaler & artist Selena Gomez from “The Big Short”
Selena Gomez & Richard H. Thaler Explaining Synthetic CDO through BLACKJACK
Selena Gomez & Richard H. Thaler Explaining Synthetic CDO through BLACKJACK
So what went wrong?
Now, let’s go back to the 2008 crisis - when the subprime market collapsed, it basically meant that a lot of borrowers had defaulted on their loans. In turn, all the structured products that were based on these loans also defaulted, sending across ripples throughout the financial system.
Here’s the thing - even though the subprime loans were given to borrowers who were likely to default (and this was known beforehand based on their credit scores), do you know what were still rated as AAA? The various structured products based on these subprime loans.
A large number of these CDOs & CMOs were rated AAA - at par with US Treasury securities - even though the underlying loans were likely to default.
If you’re asking why would credit-rating agencies do that, there’s no clear answer. They admitted to not following their standards & processes, but not of any wrongdoing.
But if you look into how the business of rating agencies function, then you might make a more informed guess. Like most firms, rating agencies also earn money from their clients - except in this case, their clients also happen to be corporates & investment banks who issue & sell these bonds. The better rating the bond gets, the better it is for the client.
On one hand, credit rating agencies should rate bonds/products based on merit/quality - but on the other hand, their clients (who pay them money) want better ratings, even if it’s not justified.
To make matters worse, the industry of credit rating agencies is highly concentrated, with top 3 players (S&P, Moody’s, and Fitch) controlling more than 90% of the global market.
So what do you think happens when one agency is willing to give in to client demands and the other isn’t? Here’s another awesome clip from “The Big Short” enacting this problem:
The Big Short Rating Agencies
The Big Short Rating Agencies
We’ll never really know whether it was the honest carelessness or systematic greed (or both) of credit rating agencies that led to these poor ratings - but what is known for a fact is the resulting destruction & ripple effects of this.
Billions of dollars destroyed, thousands of jobs lost - all mainly because greedy bankers wanted to sell a risky product, and the guards enabled them to (by mistake or by choice), instead of preventing it.
Why does this matter to me?
11 years later & back home in India, I was reminded of all this when the SEBI turned its focus on credit rating agency ICRA and their role in the IL&FS default, which effectively triggered the entire ongoing NBFC liquidity crisis.
Unlike many global regulators, SEBI not only rejected ICRA’s settlement claim, they decided to expand their probe & investigate the role of this rating agency (and others) in the IL&FS crisis.
The guard of credit rating agencies has again failed, but this time the regulator - who is supposed to guard these guards - stepped in with the objective of protecting interests of investors. SEBI believes the IL&FS default “had market-wide impact, caused losses to a large number of investors and affected the integrity of the market.”
But what if the regulator hadn’t done this, or accepted a settlement? Did you know that debt mutual funds invest in bonds based on the issued ratings? And interestingly, did you also know that the top 3 rating agencies in India are all subsidiaries of the top 3 global credit rating agencies?
  • CRISIL is owned by Standard & Poor’s (S&P)
  • ICRA is a subsidiary of Moody’s
  • CARE is a part of Fitch Ratings
Hmm, these are the same agencies who maintain, even today, that their ratings are only indicative & cannot be relied upon - yet this is exactly what most market participants continue to do, often blindly.
If you’ve invested in debt mutual funds, chances are you are impacted by this. A lot of debt/hybrid mutual fund investors have suffered in 2019 due to the IL&FS defaults and the following DHFL crisis. One of the reasons for that is because these funds invested in bonds that were “highly rated” and risk-free.
The defaulted IL&FS bonds had the highest AAA rating from ICRA. Certain DHFL bonds also had AAA rating from ICRA & CARE. That’s putting them at par with not only the Indian Government issued bonds, but also the Treasury securities issued by the US Government!
The Latin phrase mentioned in the title literally means “Who will guard the guards themselves?” While we are lucky to have a pro-active SEBI, remember that you yourself are the ultimate line of defence. So if you someone tells you that these bonds are safe because they are highly rated, remember this story and accompany the given rating with your own analysis. Or just avoid the tempting additional return if you don’t understand how/why the investment is riskier than FDs.
Especially if you see a “secure” AAA rating.
Happy investing!
-Vikas Bardia
Not making small talk :)
Hello there - my name is Vikas and I write & curate this newsletter. We’ve been sending you various stories & analyses for many months - but this time would love to hear your thoughts on this newsletter.
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