[Dark Side of the Investment Industry] Cases where ratings are softened due to undue influence

Hello, this is Gedo (Shinoyama) speaking. They say "history repeats itself," but as I have been conveying in recent newsletters, there are whispers among market participants that "the current situation resembles the pre-Lehman Brothers shock period." Therefore, to explain how they resemble each other, we in the previous newsletters introduced the historical background surrounding the Lehman shock. I think there are readers who have not read it yet, so to review, I will summarize it briefly. ※ I will convey this as clearly as possible, for those who are curious about, "how money moves behind the scenes," please take a look until the end. ↓ Around 2003–2004, loan companies began to focus on subprime loans aimed at people with low creditworthiness for home mortgages. A loan company is, in Japan, an image similar to "consumer finance." It was of course high-interest… but for people with low credit, simply being able to take out a mortgage and obtain a home was a priceless matter. Moreover, at that time housing prices in the United States were rising, so with the easy thought of "if it comes to it, we can just sell the house," many people jumped into subprime loans. On the other hand, after lending, the loan companies did not wait for repayment, but sold the loan claims to financial institutions such as investment banks and securities companies. And the funds obtained from selling loan claims were lent again to those with low creditworthiness, creating a self-perpetuating cycle. Because loan companies avoided default risk, (though they did not fully avoid it…), their screening standards gradually loosened. Also, the loan companies that bought the loan claims would securitize them as "Residential Mortgage-Backed Securities (RMBS)" and sell them to investors. That is what the previous newsletters described, right? But… isn’t there a question? RMBS are backed by loans aimed at people with low creditworthiness. Would you not think that is dangerous? Of course, there are investors who prefer high risk and high return, since there are various investment styles. But still, it is natural for investors to want to avoid dangerous things. However, they were bought in large quantities. Why? Why were the seemingly dangerous "Residential Mortgage-Backed Securities" accepted by investors? That is the theme of today’s talk. ＝＝＝＝＝＝＝＝＝＝＝＝＝＝＝＝＝＝＝＝ Why did investors take the risk and buy? ＝＝＝＝＝＝＝＝＝＝＝＝＝＝＝＝＝＝＝＝ One reason investors bought them lies in their “rating.” RMBS were inexplicably given high credit ratings by rating agencies. Strange, isn’t it. That the ratings were distorted is now obvious to everyone, but since the rating agencies gave them a seal of safety, they continued to be bought. So, concretely, what grounds led to such high ratings? For example, suppose there are 10 billion yen worth of home loans, and an investment bank considers securitizing them as assets. What is considered here is "what is the probability that these loans will default?" Suppose, based on past statistical data, "out of 10 billion yen of home loans, 7 billion yen will almost certainly be repaid." Then the securities issued with those 7 billion yen as assets would be assigned an AAA rating. This is the "senior" tranche. And the remaining 3 billion yen of loans used as assets for securities would be ranked as higher risk than the senior, as "mezzanine" and "equity," in that order. If the housing loans defaulted, the worst impact would fall on the "equity" tranche. Now, which would you choose if the options were 1: "Senior" 2: "Mezzanine" 3: "Equity"? Most people would probably choose the lowest risk "Senior." After all, "Mezzanine" is dangerous and hard to touch, right? But the issuer of the securities wants to sell the "Mezzanine" as well. ("Equity" was generally held by investment firms.) So what did they do? They mixed the "Mezzanine" with other loan assets and recast them, thus creating and selling "Collateralized Debt Obligations (CDOs)." Do you think this is safe? In theory, it was considered safe. For example, if you have "home loans" "auto loans" "consumer loans" each with a default probability of 30%, and if those risks are independent, then by multiplying them, the ultimate risk would be 0.3 × 0.3 × 0.3 = 0.027, that is, 2.7%, in theory. The risks of 30% each would drop to about 3% when mixed, seemingly making sense at first glance. If someone says, "Even if home loans default, auto and consumer loans are unaffected, so the risk is low," you might be persuaded to say, "Yes, that makes sense." But history proves this theory was wrong. In the end, rotten meat mixed with other meat remains rotten meat. There was a sad reality where many investors were misled by lax ratings. ＝＝＝＝＝＝＝＝＝＝＝＝＝＝＝＝＝＝＝＝ Cases where ratings were gamed by complacency ＝＝＝＝＝＝＝＝＝＝＝＝＝＝＝＝＝＝＝＝ Let’s sum up. For investors, ratings are an important indicator that cannot be ignored, but RMBS were rated as 1: "Senior" 2: "Mezzanine" 3: "Equity" and given high ratings for the Senior tranche. The Mezzanine tranche, which had lower ratings, was mixed with other loans and sold as a high-rated “CDO.” The Mezzanine, which should have had a low rating, became higher-rated when mixed with others, a logic that did not hold up. Reasons these actions were allowed include "rating agencies actively participated in selling CDOs" and "rating agencies earned revenue by giving lax ratings." While relating Lehman Shock this time, I hope you understand that overreliance on ratings is dangerous and diversification does not guarantee safety. Thank you again for watching until the end today. Next time, we finally get to the main topic. Building on what has been discussed so far, we will compare Lehman Shock times and the present situation to explain what’s similar and what’s dangerous. Ged Sho (Shimo) End