The ‘Sub Prime’ Bubble: The result of poor Ratings

The sub-prime bubble is a classic bubble, born from greed, but with two specific causes, poor and at worst bad ratings and bad identification.

Sub-prime as a consequence of poor or bad ratings
Regarding ratings, one view is that rating agencies wrongly extended their corporate rating expertise to financial vehicle ratings. Wrongly, because they helped to give the impression that these securitisation vehicles were equivalent to corporates, when in fact they were very different, and probably closer to imperfect markets.

The message of a securitisation vehicle to borrowers is: “come on, here is a stable source of funds”; and its message to investors is: “come on, here is a liquid rated investment”.
Both messages are false. This is a stable source of funds  “if and only if” investors maintain their interest in the vehicle, as possibly Northern Rock discovered too late, when the liquidity crisis and sub-prime scare hit the market.

And it is a liquid investment if and only if not too many investors try to exit at the same time, as BNPP investors discovered too late. Rating agencies said that their ratings were right; that the underlying sub-prime loans hidden behind their AAA investments did not fail.

This is true, but irrelevant: agencies rated a risk (default of underlying investment) which was not the risk of the investment. They helped investors believe that an investment in the AAA part of an illiquid securitisation vehicle was the same as investing in bonds of a AAA company which is totally safe and liquid.

Rating agencies were given the right to create money by regulatory authorities and they used this to create fake money. Let’s not be too negative: a) French kings did just the same and b), only a small part of the cake went to rating agencies: lawyers, auditors, and mostly, banks had their share too.

So our first conclusion is very simple: rating agencies should only rate corporates.

Sub-prime as a consequence of bad IDs
Some of the most important actors of this crisis (and of today’s market economies) are “vehicles”: Financial funds used for securitisation or for private equity. Private equity being possibly our next bubble.

We all see these funds as real companies, especially when we see in the press “fund X buys company Y”. But most of them are not a legal entities, just legal agreements, managed by a service company, usually linked to a bank. Vehicles are legal phantoms.

Is it a problem? Yes, it is. A market economy is an economy of responsibility. All our systems (including Coface systems) are based on registered legal companies, with shareholders links between them, and influence as a consequence of these links.

With these phantoms, the decision-makers are not the owners and have no real accountability. We, Coface, consolidate in our databases the subsidiaries of a group and we try to build a track record on how it manages them. We cannot do this with vehicles.

Why did this happen? Of course it is a consequence of the successful efforts of banks to increase their ROE (Return on Equity). This helps to answer one of the mysteries of modern market economies. Economists tell us that average ROE of an economy is its long term growth: with inflation, maybe around 5% for France, 8% for the whole world? So, how can banks deliver 20%, 25% now sometimes 30% ROE?

There are two ways.
The oldest trick is what we call the “Stakhanov trick”. Stakhanov was this Russian coal miner in the Soviet Union whose productivity was extraordinary. He was promoted as a model by the regime.

The truth is that a number of aides around him prepared the work for him, and their contribution was ignored when measuring Stakhanov productivity.

Part of high ROE is obtained by sending problems outside of your company profit and loss, to pressured subcontractors, controlled customers, unfunded public social systems or polluted environment.

There is now a second trick, and we call this the “vehicle trick”. If a bank can organise its activity in a vehicle, control it through a service company, with no equity and no liability, and keep part of the revenues of the vehicle in this service company, ROE on this part is infinite.

Where are the “mines” in the vehicle trick? They are with the Northern Rock and BNPP investors of our first examples. And they also come back to banks like boomerangs when they are obliged, as now, to take back the risk on their balance sheets, to protect their reputation, or because it never really left their balance sheets.

Who is ultimately responsible for this situation? We consider that regulatory bodies are. They do control banks a lot, but they control the letter more than the spirit. They looked with a benign eye at the securitisation trend (when this is clearly a way to escape control through equity ratios). Worse, they rationalise this, saying that “the dilution of risk is good for the economy”.

Hundreds of years have taught us just the contrary. Risk should be taken by regulated specialists with strong equity (banks or insurance companies). And when these specialists pass it back in an obscure way to non specialists. It usually means irresponsibility (which facilitates bubbles) and it can even destroy confidence in the market economy.
So our second conclusion is that we need to track these phantoms. And as a first and humble step, we decided in Coface to have financial vehicles “Easy Numbered” so that we can identify the risks.

CofaceZA CEO Malcolm Guest