09 02 05 – The Economist
JUST as straight-A students have been drawn to exotic areas of finance over recent decades, so have several firms with AAA credit ratings. General Electric (GE) relentlessly expanded its finance arm which handles everything from credit cards to property. American International Group (AIG) diversified from plain insurance into credit derivatives. And even Warren Buffett’s Berkshire Hathaway was tempted to write a book of equity-derivative contracts that has recently created a big mark-to-market liability in its accounts.
Just as plenty of AAA banks have been taken to the cleaners, so these non-bank firms have suffered too. AIG is now state-controlled, after huge derivative losses. Standard & Poor’s (S&P) says GE now faces a one-in-three chance of losing its rating, which it has held since 1956, largely due to problems at its financial arm. Berkshire Hathaway’s credit-default swap spreads are far above those of AAA non-bank firms, such as Exxon Mobil (see chart).
Rock-bottom borrowing costs undoubtedly created moral hazard at banks. Might AAA ratings have also tempted non-banks to take foolish risks? Not in general. The number of industrial firms with S&P’s highest credit score has dropped from over 60 in the 1980s to just six today, but this largely reflects shareholder pressure on firms to gear-up core businesses, or a dimming of their industry’s prospects.
A few firms do seem to have sought exposure to finance precisely because they wanted to exploit their high ratings, however. “My gut told me that…this business seemed an easy way to make money,” wrote Jack Welch, GE’s former boss. It was about “finding smart and creative people and then using GE’s strong balance-sheet.” When AIG set up its credit-derivatives arm in the 1980s it hired specialists from the junk-bond shop Drexel Burnham Lambert, who were attracted partly by the potential to piggyback off AIG’s excellent rating.
Such instincts are not always wrong. Risky activities can create losses and should eventually raise a firm’s overall cost of borrowing—but that is acceptable if the profits compensate.
Ajit Jain, an executive at Berkshire Hathaway, has said that with its AAA rating the firm has toyed with entering the bond-insurance market for the past 20 years. Only recently, after the collapse of the industry, have prices risen to a level that Berkshire finds attractive.
Even if the prices are right, depending on being AAA-rated for survival is a treacherous strategy. This has little to do with the small rise in borrowing costs a lower rating might prompt; the real danger is from the collateral calls that counterparties can demand. Like some banks, AIG found that downgrades fed a fatal liquidity crisis. Reassuringly, Berkshire Hathaway says most of its equity derivatives do not require collateral postings. GE, meanwhile, insists that a downgrade would have no “major” impact. Although an AAA rating is nice and exploiting it can make sense, nobody should become its slave.