When the credit rating agency (CRA) Standard & Poor’s downgraded U.S. sovereign debt on Friday night, it was the financial equivalent of shock and awe. News sites, news shows and Twitter were abuzz with the news. Though the timing of the news was a surprise, coming as it did shortly after the debt ceiling deal, the downgrade of U.S. debt was almost inevitable and one that the credit ratings agencies themselves helped create.
Rather than being the main contributing event to the downgrade, the debt ceiling debacle, which certainly showcased the ineptitude of Congress and the sad state of fiscal affairs in Washington, DC, was just the icing on the cake following a decade of catastrophic financial mismanagement. From what used to be a budget surplus, the US has run up unprecedented budged deficits fueled by tax cuts for the rich and powerful, two wars that show no signs of ending and a wholesale bailout of the very financial institutions that took a leading role in the financial crisis in the first place.
The credit bubble of the early and mid-2000s has been well documented. Fed by a loose money policy from the Federal Reserve and aided and abetted by lenders, mortgage brokers, appraisers, securities firms and credit ratings agencies, the US blew up a gigantic housing and credit bubble. Securities firms packaged mortgages and sold them to investors around the globe, who snapped them up because of their high credit ratings and relatively generous yields. Unfortunately, many of those securities were build around sub-prime mortgages.
In retrospect, we’ve learned that the subprime mortgage market was rife with fraud from beginning to end. Not only were many buyers fraudulently induced to buy homes that they could have never afforded, many criminals also obtained mortgages under false pretenses. Some mortgage brokers and loan officers pushed through mortgages that they knew would never be repaid. Securities firms had a voracious appetite for these mortgages, which they securitized to investors seeking higher yields. Many residential mortgage backed securities were packaged into collateralized debt obligations.
That’s where the credit rating agencies come in. The job of credit rating agencies is to assign a rating that reflects how likely a certain bond issue and bond issuer is to default. The highest rated bonds, AAA, are deemed the safest.
The compensation structure surrounding credit ratings is an inherently flawed one, as the very securities firms that seek the credit rating pay for that rating. Securities firms could, and did, play the credit rating firms off each other in an effort to get the best ratings for their prime and sub-prime mortgage securities.
And that wasn’t the only flaw in the system. In many cases, the credit rating firms didn’t independently verify the information provided to them about the mortgages packaged into securities. In retrospect, it became evident that their models were seriously flawed as far many more mortgages that were ever anticipated went into default.
When the system blew up, beginning in 2007 and into 2008, it seemed like the only path towards rescuing the global economy was a massive bailout of financial institutions. It was that, or see the whole system come down in flames.
Trillions of dollars were poured into that rescue efforts by the U.S. and other Western governments. While this massive transfer of funds from the people and their governments to the banks did succeed in rescuing the banks and the financial system itself, it was a hollow victory. Like an addict in search of a fix, once the global financial elite realized that the system was, indeed, too big to fail, they had no reason not to continue to take massive risks with other people’s money.
While the system was “saved” in a sense, it still isn’t whole. Imperiled by huge sovereign debts created by bank bailouts, Europe is struggling with a crisis that may very well spell the end of the Euro Zone. In the U.S., the budget deficit is swollen by bank bailouts and tax cuts.
This current sovereign debt crisis has the potential to further savage bank balance sheets, as downgraded debt is eventually written down to market value. Some analysts believe that what’s going on in Europe is that continent’s Lehman moment, the tipping point in a crisis that could again spread across the globe, creating Global Financial Crisis 2.0 (#gfc2). Sped by credit rating downgrades, the global financial system is once again heading towards economic armegeddon.
Which brings us back to the credit rating agencies. There’s no doubt that they were instrumental in creating the first global financial crisis which as led, inevitably, to the second one. As they downgrade sovereign debt across the globe, it’s important to realize that these downgrades are a self-fulfilling prophecy in several senses.
First of all, by their involvement in the first financial crisis, they set the stage for the bailouts that are now crippling sovereign governments. Secondly, through downgrades, they are worsening an already bad situation. Downgrades tend to be a vicious cycle which lead to further downgrades. Thirdly, by threatening downgrades unless countries adopt austerity, they are helping kill any hope of economic recovery, which makes more downgrades likely.