The ratings agencies were the latest attendees in the congressional parade of shame today so I thought I would provide readers with some background on why these ratings are so important and the role they play in the markets.
The following is a lift from my upcoming book "From Your Wallets to Their Pockets"...
Why are Ratings Downgrades a Problem?
The problem with ratings downgrades is that they have a tremendous rippling effect throughout the financial, public, and private sectors. Ratings downgrades reflect the fact that the security is riskier than the initial rating suggested and the current market value is lower. This means the initial return expectation is now lower and the possibility exists of loss of the investor’s principal and interest.
The broad spectrum of investors in these securities includes employee pension funds, insurance companies, other banks and financial institutions, municipalities (such the county in which you live and work), private investors, major corporations, other governments, and other governments’ financial institutions, to name a few.
Investors
Investors in these now-riskier securities face two issues. First, they were expecting a profit on their investment. Second, the current value of those investments is reflected in their financial statements on their balance sheets.
With regard to the expectation of profit on the investment, the investor relied on the initial risk/reward analysis, which has now proven to be flawed. Now the investor is receiving a rate of return far lower than another investment of similar (or perhaps now more or less) risk would pay.
Loss of the investment means more than just the bonds becoming worthless. Those who invested in them have lost not only the profit they expected to earn but also the money (the principal amount) they used to purchase the investment.
Then there’s the matter of the balance sheet. As these securities decline in value, they must be marked-to-market, or written down to their current value in the market. Not only does this write-down lower the value of the company that made this bad investment but, in many cases, these changes are so significant that the company cannot stay in compliance with its own operating charters or regulatory requirements.
Consider, for example, Bank XYZ. Bank XYZ has invested $1 billion in these securities and has an adequate capital ratio as required to stay in business. The securities in which they invested are then downgraded and the marked-to-market value is now only $500 million. This $500 million loss in value reduces Bank XYZ’s capital level to an inadequately capitalized condition that must be rectified immediately. Bank XYZ has a few options to raise this additional required capital:
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sell more stock, which raises equity capital and dilutes the existing shareholders’ equity;
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borrow the money, which involves paying interest at a higher rate, since the loan to the bank is now to a “riskier” organization;
- sell part of the business, losing more control and diluting current owners’ equity;
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sell off other higher-performing assets to get the balances down to the bank’s new level of capital; or
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sell the downgraded securities at a significant loss… if there are any buyers!
All of these options are extremely costly and sometimes making decisions like these put companies out of business.
Public municipalities can find themselves in similar predicaments. I happen to reside in Orange County, California, so even if I weren’t in this business, I can honestly say I have firsthand knowledge of how this works. My fellow taxpayers (and my family and I) in Orange County are still paying for the county’s bankruptcy due to a different financial debacle in December 1994.
Let’s say that, as part of investment plan for cash on the balance sheet, Orange County purchased subprime mortgage-backed bonds or CDOs and that these bonds defaulted or were downgraded. This would effect the county in two ways. First, the county would have lost taxpayer dollars from its operating budget and, unless cash was in abundance, it would have to make up the loss from somewhere else. Second, if the amount of the loss was significant enough, it would result in the county’s own credit rating being downgraded. Since the county borrows money in the form of bonds, its ratings downgrade would require it (readers are encouraged to interpret that “it” as “we taxpayers”) to pay higher rates of interest for that borrowed money.
The recent, unprecedented actions by the Federal Reserve Bank have this same effect. The bailout of Bear Stearns included the Fed taking almost $30 billion of these types of securities (funded and managed securities) onto its books. Bear Sterns is not a member of the Federal Reserve System and any further loss (and, as the Fed kindly points out, “profits”) will be at the taxpayers’ expense or gain. JPMorgan Chase picked up a competitor and its good business assets at an astoundingly low price at the Fed’s behest, and the Fed took on the worst of it to make the deal happen.
The Fed’s new Term Auction Facility expands, for the first time, the collateral that may be used to borrow money from the Fed. Now, the Fed allows poorer performing security, including mortgage-backed securities, to be used as collateral. No need to give us your Mercedes as collateral; we’ll be happy with that beat-up old Pinto. Another shining example of privatizing profits and socializing losses.
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