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Posted on October 14, 2008 - by

Standard & Poor’s Role in the Credit Crash

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Standard & Poor’s Role in the Credit Crash

Russia’s Interfax news agency published a short article by Sergei Vybornov, president of the ALROSA corporation, touching on the subject of S&P’s responsibility for the global lending industry crisis. ALROSA is Russia’s largest diamond mining company handling a quarter of the world’s natural diamond production. Sergei Vybornov – a diplomat in the past – is a graduate of the Wharton School of the University of Pennsylvania. I thought he made a good point bringing into question S&P’s methodology and professionalism awarding high credit ratings to essentially bankrupt banks and lending institutions.

“What scientific methods of understanding the reality surrounding them were used by the S&P analysts, who, for many years, awarded high credit rating to unsecured obligations worth trillions? In what ways do such agencies award credit scores to banks now being bought up en masse by national governments? What do they analyze? In this case, methodology doesn’t really matter anymore, because once again the crisis demonstrated that there are no methods behind any of this. And, therefore, there is no use considering something that doesn’t work and, probably, will never work again.”

Indeed, if you look up history of S&P reports for the failed lending institutions in the US, you will discover that nearly all of them had nothing short of stellar credit ratings. Until shit hit the fan, that is. This really leaves just two possibilities: S&P is either staffed entirely by bungling dimwits, who can’t tell a triple-A-plus credit rating from bankruptcy, or we have the classic case of one hand washing another.

Looking at the credentials of leading S&P analysts, it becomes clear that they are no chumps. Just like unscrupulous house appraisers are working with mortgage salesmen to inflate real estate prices, credit rating agencies are bloating the value of the lending institutions, while effectively masking their voodoo craft with complex mambo-jumbo of credit evaluation reports.

I can’t speak for credit ratings of banks, but I am intimately familiar with my own credit rating and here’s a little story of how I bought my house. For a while I’ve been living in upscale apartments and my rent payment was no different from what many people pay for their mortgage on a 4-5 bedroom house. I am lazy and I liked the fact that someone else was mowing my lawn, fixing my dishwasher and taking care of all those little things that make up the core of Home Depot’s income. And everything was great until one hot summer day I came back from vacation and discovered that by AC was broken. The management refused to send out a maintenance guy, saying that the office closes at 5pm and it was already 5:05pm.

That pissed me off. As I was sitting on the deck under a beach umbrella, surrounded by three fans and typing an email to my lawyer, it occurred to me that maybe buying a house is not such a bad idea. After a quick meeting with a Chase mortgage agent the following week I discovered that my credit rating was not exactly peachy. It wasn’t terrible, but it wasn’t very good either. I wanted to address the situation before buying a house to get a better rate.

I was surprised: I make good money and have no debts to speak of, so why would my rating be anything less than excellent? I never really looked at my credit rating before and, it seemed that due to my laziness and lack of attention to detail, there was a history of late payments, some derogatory remarks, and even a judgment from a number of years back, which was paid off but was still sitting on my record. It was so long ago, I couldn’t even remember the details.

I know people spend many months and a lot of time trying to fix their credit. I ordered credit reports from the Big Three and for every negative item on these reports I wrote a dispute letter – even for the perfectly valid items – using the ever popular copy-paste narrative style. It took me about an hour, half of which I spent trying to clear a jammed envelope from my printer. Three weeks later every single negative record disappeared from my credit history. Then I applied for a bunch of credit cards to improve my credit-to-debt ratio and bought three red leather armchairs for my home theater – to enhance my credit history and to facilitate my Master Chief career in Halo on Xbox Live. And that was pretty much it: I got my rating to 750, bought the house and replaced the AC unit with an industrial-grade system to keep all my computers nice and cool in the basement.

The mortgage agent at Chase was surprised when just over a month from my original visit, my credit rating came back as a shining indicator of my fiscal responsibility. “I don’t know how you did it, but it works for me,” he said. He was very persistent in trying to get me into a house which was at the very top of my credit range, talking up the advantages of variable APR and other such mortgage honeypots. I just had to tell him that I don’t really need a 5,000 sq. ft. house with a four-car garage. I only have one car and my cat and I don’t plan on playing indoor tennis. It was tempting, though, and I can see how people with just a bit less self-restraint could have gotten themselves into mortgages they could barely afford and into situations where every unexpected expense threatened their ability to make payments.

Sure, we can blame folks who overextended themselves and defaulted on their subprime mortgages. But it’s kind’a silly to believe that these people are responsible for the massive meltdown of the global financial markets. Just a tiny percentage of subprime mortgages result in foreclosures. In 2005 this figure, I believe, was about 3-4% vs 1-2% for standard mortgages. Not a huge difference. What kills people are the refinance deals (you’ve seen all those adds on TV that have mysteriously disappeared along with Bear Stearns and co.) that many got themselves into in hopes of escaping the subprime ripoff. These refinance deals are something else altogether and raise the foreclosure rate by nearly a factor of ten. Save a penny, lose a dollar.

The three-month foreclosure moratorium proposed by Obama is a nice gesture. It will help some homeowners who just need a bit more time to find a new job or to pay off other debts. But if you could barely afford your home when the economy was good (well, better than now), three months will just keep the jackals away for a while longer. Something much more radical is needed here, like a substantial change in the bankruptcy law that would allow people to keep their primary residence under a wider range of circumstances, or a government-sponsored refinance deal with a generous grace period. Would this be fair to the lenders? Maybe not, but they deserve a punishment. Besides, with the government now in control of most lending institutions, both the lenders and the borrowers are us – the average taxpayers. I think we can come to an agreement.

Unfortunately, many Americans still try to be honest and to deal fairly with the predatory lenders who got them into the jam in the first place. People call their banks and beg for forbearance or some other handout, while they should be considering bankruptcy, which would keep them in their home for at least six months and often over a year. Bankruptcy laws of many states offer up to a year of right of redemption, thus allowing you to stay in your home, wipe off your other debts, and then pay past-due mortgage. Instead of wasting money on silly and expensive refinancing schemes, distressed homeowners are better off spending this cash on a good bankruptcy lawyer.

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This entry was posted on Tuesday, October 14th, 2008 at 6:38 pm and is filed under Economy, Featured, Personal, United States. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.

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    October 15, 2008

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    Ledovik said:

    Hello Venik,
    Appreciate all the commentary.
    Hope all is well.
    _ and Iceland? – seems hardly mentioned
    _ and can find nothing on Kenya/Somalia
    Ledovik

    Reply



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    October 15, 2008

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    Giuseppe Flavio said:

    Hello Venik, I’m not sure to have understood correctly some of the things you have written here. Perhaps these are obvious for people living in the US, but not for me because I live in Italy and only had a short one week stay there.
    1) How does the mortgage agent know about your credit? Is there some state-controlled agency that makes the credit ratings or the “Big Three” do it?
    2) Along with the rebuttal letter, is it needed to pay a fee for the review?
    3) Why having more credit cards and using them improves someone’s credit? To me it simply means having some more debt and the willingness to do more.
    BTW, if the answer to 1) is the “Big three” and the answer to 2) is “Yes”, to me it’s a form of legal and practically mandatory bribing.

    Cheers.

    Reply

    Venik Reply:
    October 16th, 2008 at 1:27 am

    When applying for a line of credit, such as mortgage, you authorize the lending agency to obtain a copy of your credit report. The lender would usually access your online credit report during your initial meeting. The Big Three credit reporting agencies are Experian, TransUnion, and Equifax. The mortgage agent – who works on commission and wants you to buy the house – will usually pick one of the three reports – the one showing best credit record.

    You are entitled to one free yearly copy of your own credit report from each credit reporting agency. You can dispute any negative item on your credit report free of charge. The credit agency will attempt to contact the specific lender in question to verify information on your credit report. Quite often the loan in question has been sold and resold since the time you originally borrowed, and so the lender does not always respond to the inquiry and the credit reporting agency removes any negative entries it could not verify.

    Your credit score (FICO score) is calculated using a complex formula with parameters that change from year to year, depending on the economic situation. One of the parameters is the debt-to-credit ratio. Getting a new credit card with a few thousand bucks of credit line improves this ratio. Silly, I know, but that’s how they operate. There is certain logic behind this, though. If you have a generous credit line you are less likely to run out of money and default on your debts in short term should you hit some rough waters. But that’s only in short term.

    Another parameter is credit history: having big purchases and regular, good-size payments on your credit cards improves your credit history and increases your FICO score. From time to time, when I buy something expensive, I would use a credit card, even though I have money in the bank. I would then repay the credit within 25 days to avoid finance charges. This costs me nothing, but creates an appearance of active credit and timely payment history.

    Reply

    Giuseppe Flavio Reply:
    October 16th, 2008 at 10:33 am

    Thanks for your answer Venik. I had read someone blaming poor people (especially Hispanics and Blacks) for cheating in order to get their mortgage loans, thus causing the current financial havoc. I didn’t believed this theory, but now I’m realizing that there is some truth in it. Borrowers have lied, because lenders wanted to be cheated, in order to cheat someone else.

    Reply

    Venik Reply:
    October 16th, 2008 at 1:52 pm

    The credit verification process is actually very thorough. The main problem here is that the mortgage agent works on commission. He may also recommend you the real estate agent, who, in turn, will recommend you the home inspector. And the bank appraiser works with the mortgage agent. So you have key four people working on this deal and all of them may be getting their cut beyond their official fee or commission. The mortgage agent I worked with was actually a friend of the family and he made things easy for me. Even so, he still tried – by force of habit, I guess – to push me into the top of my buying range, even though he knew I did not need a huge house.



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    October 19, 2008

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    Peter Coates said:

    Venik

    I used to have a credit rating problem as well in that I’d never had a credit card till 2003.

    I had paid off two mortgages by then but my ability to function without a credit card truly bamboozled lenders.

    So eventually I gave in and got a card – annual fees and all. Now the lenders are happy.

    –

    BTW I here that the financial crisis is hitting Russia hard “Russia’s good times fade as economy suffers” http://ap.google.com/article/ALeqM5h3n–b2uZ_QLsgBJyDbEyzbZJ9dwD93T0NMO1 .

    How do you think this might effect Russia’s use of oil and gas as a foriegn policy lever?

    Regards

    Pete

    Reply

    Venik Reply:
    October 19th, 2008 at 5:41 am

    Yes, I read this article earlier today. There was a good interview with Interfax’s chief of economic analysis department: http://www.interfax.ru/txt.asp?id=39683 Unfortunately, the article is too long for me to translate to English.

    To summarize, reduction in capitalization of Russian companies trading on RTS has very little impact on Russia’s economy. The credit crunch is the primary issue. However, this analyst is of the impression that the Russian government is overreacting to the crisis and doing too much too soon. He does not believe the government should be directly refinancing foreign debts of Russian companies, but instead acting as a guarantor for further negotiations with the original creditors.

    Russian economy is still very different from the West and the result of this crisis will be different as well. I think the authorities should keep the exchange open and let stocks fall as far as they’ll go, instead of halting trading on rapid fall or growth. Already, stocks of many Russian companies are below their actual value. The government has the cash to get in on the action and kill two birds with one stone: support the market and, in a year or two, make a good deal of profit.

    Surprising as it may sound, many financial analysts are of the opinion that the Russian government is acting too conservatively, too capitalistically, unlike the US and the EU, both of which resorted to socialist methods to keep their lending bubbles afloat.

    Reply

    JLD Reply:
    October 19th, 2008 at 6:43 am

    Russian economy is still very different from the West

    LOL
    Sorry Venik but this only sounds like more wishful thinking, you definitely don’t want to look at the bleak side.
    Whereas Russia’s good times fade as economy suffers, I know, I know, this is also propaganda from the other side but actual facts are likely to stand somewhere in between.
    And BTW, this is what I was talking about when I said that, may be, just may be there could be some geopolitical purposes for the crash.
    It’s also “convenient” that it hurts other oil based economies, like… Iran?

    Reply

    Venik Reply:
    October 20th, 2008 at 2:02 am

    I did not say there was not impact on Russia’s economy. It’s just everybody is watching the RTS index as an indicator of such impact and it’s the wrong place to be looking for signs of trouble. There is only about a million Russian individuals who trade stocks on RTS either directly or through various investment funds. The rest are corporate players. It’s a tiny percentage of the population, especially compared to the level of public participation in stock trading in the US, where virtually everyone with a pension plan depends on NYSE.

    The real threat to Russia’s economy is limited access to credit. This threatens the average guy. Projects are on hold, companies are forced to downsize, employees are being laid off. As far as government’s response to the crisis, the danger is the same as in the US: spending taxpayer rubles to prop up giant corporations. But in Russia it’s a bit different, since the government owns a piece of most big companies.

    To say there are geopolitical purposes is to imply that someone out there has the capacity to engineer a global financial crisis. Nobody has this kind of power. And why would anyone want to do something like this? To bring down oil prices? This is like using a baseball bat to swat a fly on your nose. The drop in oil prices is temporary and it’s not hurting Iran or Russia (not yet). This drop is not supported by an actual decline in demand and, therefore, prices are bound to go up soon. There are easier and far cheaper ways to do harm to Iran’s economy.



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