IT'S HARD TO OVERSTATE the impact of the great financial crash of 2008: around 40% of the world’s apparent wealth disappeared practically overnight, and huge US corporations such as Merrill Lynch, Citibank, AIG and General Motors had to be rescued from collapse.
The largest company in the world by booked assets was our very own Royal Bank of Scotland and the outcome was that both of our 300-year old Scottish banks were wiped out and are now largely owned by the UK Government.
As a result of the crash, changes are underway to try and ensure that it doesn’t happen again, mostly concerned with ensuring that banks have a larger cushion of equity and are no longer ‘too big to fail’.
But if we examine what actually caused the crash in the first place - all the dodgy loans that were apparently top rated AAA investments but turned out to be worthless - it is staggering to realise that nothing much has actually changed, for the Credit Ratings Agencies (CRAs) that blessed the investments continue to operate essentially unreformed.
The modern financial system couldn’t operate without the CRAs; they provide the supposedly independent qualification of financial risk on which key investment decisions are made. However the financial crisis happened because investment ratings stopped being things that had to be earned, and turned into things that could be paid for.
At one time the work of the CRAs was paid for by subscribers to their reports but as the workload grew a new methodology developed known as ‘issuer pays’, where the promoters of an investment deal paid a CRA to develop a rating for it.
You may find this difficult to believe so I’ll just state it again: the promoters of an investment deal, the very people who want to sell it, pay for the rating that will help sell the product. It’s like one side paying the judge in a court case, or Hollywood paying the salaries of film reviewers. It is literally incredible.
The essential conflicts incurred by this type of deal was first exposed when Enron and Worldcom collapsed in 2002 and it emerged that the CRAs, whom they had paid, still rated them AAA only days before they went bust. And in some recent investigations and court cases by aggrieved investors the obvious conflict of interests underlying the 2008 collapse have been exposed.
A US Senate subcommittee uncovered emails from one ratings agency employee who said he wanted to “discuss adjusting criteria” for assessing housing-backed securities “because of the ongoing threat of losing deals”.
Matt Taibbi, in a recent piece in Rolling Stone magazine reports comments from staff working for CRAs such as: “this has to be the stupidest place I have worked at” and “Let’s hope we are all wealthy and retired by the time this house of cards falters”.
According to Taibbi, Morgan Stanley put together deals in which bank executives would earns ‘big fat upfront fees’ despite internal memorandums that indicated that they knew they were stuffing such products with ‘highly suspect’ loans.
And there was a lot of similar stuff about. Of the hundreds of billions of dollars of the AAA-rated subprime, mortgage backed securities in 2006, 93 per cent subsequently turned out to be junk.
This April, Moodys and Standard & Poors settled out of court with a group of unhappy investors for a reported $225m and their share price soared, so I guess we can stop worrying, after all their AAA ratings remain the best that money can buy.