Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Meeting the credit rating agencies

Debt instruments (financial products issued in order to borrow money) can be complicated. Moreover, so many exist that no single person can be reasonably expected to understand the ins and outs of the products on offer in order to compare them – plus, all the different groups trying to borrow money: governments, large corporations, banks, households and so on. You can see how easily things get messy, quickly.

To help potential lenders work out how likely they are to be repaid, companies called credit rating agencies assess how risky a product is. In doing so, they take into account a number of things, including


Financial ‘health’ of the borrower: How much debt does it already hold? Is it likely to make a profit or a loss in the future? If it’s a government, is it running a budget deficit or a surplus?


Reputation of the borrower: Is the borrower a rich government with a history of making repayments or a company that defaulted in the recent past?


Terms of the contract: In what circumstances will the lender get repaid?

If the borrower finds itself in financial difficulty and can’t cover all its liabilities, in what order do lenders get repaid? This aspect is called the seniority of the debt.

Three main credit rating agencies exist: S&P, Moody’s and Fitch. They all have slightly different ways of making ratings, but here’s roughly how they go, from best to worst:


AAA: Typically corresponds to the safest products – the borrower defaulting is almost inconceivable.


AA: Slightly more risky, but still very safe.


A: Still pretty safe, but not as safe as AA.


BBB: Getting into riskier territory.


BB, B, CCC, CC, C: Progressively riskier loans.


D: The borrower has defaulted.

Now, the credit rating agencies were asked to give ratings on different mortgage-backed securities (financial products that rely on people repaying their mortgages in order for the holders to get paid), such as the tranches of loans shown in Figure 16-1. They gave a number of these products very high ratings – they even accorded some of them an AAA rating, meaning in theory that they were as safe as the government bonds of the world’s richest countries!

In fact, of course, these mortgage-backed securities were anything but safe. When US house prices started to fall in the mid-2000s, many subprime mortgages went into default. As house prices continued to fall, many people found that the current value of their property was less than their outstanding mortgage. In other words, they had negative equity. Instead of struggling to repay their hefty mortgages, many people defaulted, reducing house prices even further and leading to more defaults – a vicious cycle ensued.

Those ‘top tranche’ mortgages that were supposedly as good as gold were finally revealed as fool’s gold! Sadly, by the time people realised that these ‘AAA’ securities were about as safe as being owed money by Del Boy, it was already too late.