| Credit Ratings |
Before the late 1970s, U.S. mortgage lending was a simple business. Prospective homeowners would visit their local bank and ask for a loan; the bank would then do a credit check and decide how much money it could loan, as well as what interest rate it would charge.
Normally, the bank held mortgage loans until maturity or until they were paid off -- the bank would simply collect interest on the mortgage until the loan matured. If a borrower failed to pay, then the bank simply grabbed the house as collateral. Mortgages, like commercial loans and savings accounts, were just another part of the banking business.
Wall Street was never very interested in the mortgage business. After all, institutional buyers generally buy stocks and bonds in large quantities, and residential mortgages covered only an individual house or condominium -- too small a sum to be of much interest. And then there's credit risk -- no Wall Street trader was going to try to evaluate the creditworthiness of an individual borrower or multiple homebuyers.
But by the early 1980s this entire market had changed. The humble mortgage, long the province of local bankers, became big business.
The catalyst for the shift: bankers began grouping together hundreds of mortgages into a single security -- a mortgage bond. The buyer of the mortgage bond would then receive interest and principle repayments for the life of the bond -- payments made by individual homebuyers were passed through to the bondholder. That made mortgage bonds large enough to be interesting to institutional players.
Later a still more sophisticated instrument emerged -- the collateralized mortgage obligation, or CMO. CMOs divided a pool of residential mortgages into tranches based on the date the mortgage came due and the interest rate of the loan. This further standardized the mortgage until it began to look like any other bond.
The result: a mortgage boom. Suddenly, banks sitting on piles of residential mortgage loans could sell their loans to an agency that would package them into CMOs. Those loans could then be sold to institutional managers and traded like any other bond.
Because
individual banks could sell bonds and pass off their risks, consumers found it
easier to finance their home purchases. Meanwhile, banks freed up capital and
institutional traders picked up yet another bond asset class; mortgage bonds
generally offered slightly higher interest rates than government debt of similar
maturity.
Packaging mortgages into bonds was an early form of what's known as securitization. And Wall Street didn't stop with mortgages -- nowadays there are more than 200 different types of securitized bonds traded around the world.
For example, like mortgages, credit card debt is another loan that's unattractive to institutions in its basic form. But by packaging hundreds of credit card receivables into a pool, card issuers can create a bond. And by securitizing credit card debt into bonds, banks and card issuers can spread their risk and raise capital for further lending.
In
fact, almost $70 billion in credit card bonds are issued in the U.S. alone.
Other examples include securitized automobile loans and home equity lines of
credit. As you can see in my chart, such loan instruments -- known collectively
as asset-backed securities -- have seen tremendous growth in the past decade.
That's great news for the credit ratings business. The increasing complexity of financial transactions and bonds spells a boom in demand for companies that analyze, research and offer advice on such deals. At the heart of this trend lies the credit ratings industry.
Institutional investors looking to buy a particular bond -- whether asset-backed, mortgage backed or conventional -- need to have that investment rated by one of the major nationally recognized credit ratings agencies. The issuer of the bond actually pays the credit ratings firm to rate its bonds, and in most cases institutional investors require ratings from at least two ratings firms. Companies issuing bonds or asset-backed deals need to pay to have their bond and debt offerings rated, otherwise they simply can't sell them to institutions.
As you might expect, the increasing complexity of asset-backed deals has spelled big business for credit ratings firms. Even better, these deals are more complex than traditional corporate and government bond offerings. As a result, not only have the ratings firms seen more business, but they're also able to charge a higher fee for analyzing more complex deals.
And increasing complexity of bond deals is only the tip of the iceberg when it comes to growth prospects for credit ratings firms. Traditionally, the U.S. and a handful of bigger European countries were the world's major bond issuers. Companies in emerging markets were just too small to list and trade bonds on the global markets, and as a result, they relied primarily on loans from local banks to fund expansion. For that matter, even companies in more developed European and Asian nations have traditionally relied heavily on bank debt rather than bond issuance to raise capital.
That's rapidly changing. Companies throughout the world are finding that issuing bonds and accessing the global capital markets is a cheaper way to raise money. This has led to an explosion of corporate and government debt offerings from emerging and developed markets alike.
Just as with asset-backed bonds, foreign issues must be rated by the major ratings agencies before institutional investors can jump in. This spells even more business for the industry.
The ratings business is essentially a duopoly between two firms -- Standard & Poor's and Moody's. In the U.S., ratings agencies are certified and regulated by the government, thus, there is a regulatory barrier preventing new firms from entering the business to compete with these two giants.
These two firms together control 80% or more of the global ratings business. And although a handful of smaller players also compete in this market, most debt issuers prefer to have their deals rated by S&P and Moody's, as it adds additional weight and legitimacy to their offerings. This is also true outside the U.S.
There have been some attempts to break
this near monopoly. Congress has proposed legislation that would make it easier
for firms to be certified as ratings agencies. But the effects of this
legislation are to be minimal. The two major ratings firms have spent years
establishing credibility and relationships with institutional investors and
issuing companies. Thus, it will be hard for new competitors to break into the
business and take significant share.
Investors looking for a solid, low-risk investment can look toward the
credit-ratings industry to find just that. And with the growing need for credit
ratings, the future looks bright for this corner of the market.
