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Britain's Prime Minister David Cameron, left, chairs the first meeting of the National Security Council on Wednesday. Others in attendance included Chief of the Defence Staff Sir Jock Stirrup and Home Secretary Theresa May. (POOL/REUTERS/)
Britain's Prime Minister David Cameron, left, chairs the first meeting of the National Security Council on Wednesday. Others in attendance included Chief of the Defence Staff Sir Jock Stirrup and Home Secretary Theresa May. (POOL/REUTERS/)

Derek Decloet

Debt raters too easy on the U.K.'s 'lazy money' Add to ...

Dear friends and readers, have we got an investment opportunity for you.

We have this good friend, you see, a salt-of-the-Earth guy. Actually, you could say he's more like a distant relative. We've been through a lot together, and while his greatest glories are probably in the past ... did we mention that he's a great guy?

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Anyhow, he has fallen on hard times, partly of his own making. Through the credit boom, when the bonus money was flowing as freely as $300 bottles of Bordeaux, our friend (he works in banking, primarily) spent even more freely. He outspent his income, year after year, though he didn't see the added debt as a reason to worry, since his real estate and other investments were rising so quickly.

That didn't last forever, and when the recession hit, the good stuff - the big income, the inflated home values - vanished while the debts remained. Our friend is making some adjustments, but it's tricky to change overnight the lifestyle to which one has become accustomed, no? Plus, he has mouths to feed. So he's deep in the hole, and (getting to the crux of the matter) wants a large, 10-year loan at 3.74 per cent, while he gets back on his feet.

Collateral? Ahem. The loan would be secured by his good word. But this shouldn't matter, because he has an extremely high credit score. The highest. So that seals the deal, right?

No?

Okay, time to 'fess up. The mystery friend is the United Kingdom, home of a new Tory-led government and a hulking budget deficit that will cast a shadow over everything Prime Minister David Cameron does in his first years in office. If Britons were as obsessive about fixing their public finances as they are about Wayne Rooney's injured groin, they'd be running a budget surplus by now. Instead, last year's deficit (11.5 per cent of GDP, according to Eurostat) was bigger than Portugal's, on par with Spain's and not so far below Greece's, all card-carrying members of the PIGS club.

And yes, there are apparently a lot of investors willing to lend the Brits money for 10 years at 3.74 per cent.

This comes after nearly a decade of deficit spending that, all told, has doubled Britain's debt-to-GDP ratio in the space of just seven years. Its demographics are worse than those of the United States and, like most aging Western countries, it faces a looming crunch in the health care and pension systems.

So how can it borrow so cheaply still? Even lending the British government your hard-earned money for 30 years will earn barely more than 4 per cent interest. That's because it's a big economy with the ultimate stamp of approval: The rating agencies call it triple-A, a rating that implies that there is a near-zero chance it will ever default. That may turn out to be right. But the bigger question is why the holy word of the rating agencies ought to matter as much as it still does.

In examining the causes of the financial crisis, it's obvious now that they played a key role in it - underestimating the risks in the U.S. housing market, missing wildly in their estimates of the number of mortgages that would default, and bestowing triple-A ratings on garbage. When the junk was exposed for what it was, it undermined the balance sheets of major global banks, sending the global financial system into deep trouble.

Supposedly, and in hindsight, the biggest single reason the rating agencies blew it is the conflict of interest in their business. Credit raters are paid by those who issue bonds to give ratings on them. This encourages those who want to sell packages of subprime mortgages (for example) to shop around for the agency willing to give the best grade, the same way some university students shop for the easiest courses.

Some politicians say the solution is to insert the government as a middleman. Under one proposal passed by the U.S. Senate, an government-mandated board would decide whether Moody's or Standard & Poor's or whoever would rate certain securities. It seems a half-baked solution, fraught with its own potential conflicts (what if Moody's thought it should strip the triple-A rating from the U.S. government?).

Worse, it misses the real problem. What if the issue is not that rating agencies are conflicted, but that they are simply not as good as we think at analyzing highly complex events? "The biggest problem is that lazy money depends on rating agencies," says one of the smartest debt investors I know. They shouldn't, this person says: Rating agency analysts are typically underpaid, overworked, and the good ones are inevitably picked off by Bay Street or Wall Street firms that will pay them a lot more.

Here's a modest prediction: Some time in the next several years, the rating agencies will be exposed again, this time by underestimating the risk in the government debt of some major economy. And, just as in the crisis of 2008-09, the investors who make the big money will be the ones who ignore credit ratings altogether and do their own homework.

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