Courtesy: http://www.uscg.mil/history/gifs/Pendleton_Sinking_Ship.jpg
EVERYBODY STOP WHAT YOU ARE DOING!!!! BIG NEWS!!! CREDIT AGENCIES ARE BEING REFORMED!!!
Okay… we admit that we here at USDemocrazy didn’t know what a credit agency was until 10 minutes ago….BUT HOLD ON! This is real important stuff!
But we have learned that these agencies were one of the key players if not THE KEY players in triggering the economic recession.
Yeah, that big bad ugly Whatchamacallit that may have lightened your piggy bank or even worst – taken your job or your home.
To help us learn about credit rating agencies, USDemocrazy spoke to Georgetown Professor of Economics, Korok Ray. Here’s what Ray had to say…and trust us, if we can understand this stuff, you will too! Here’s how the dreaded credit agencies work:
Meet Larry and meet Bill. Larry is a bank and Bill is a business. Bill needs some money so he visits Larry and asks for a loan.
Larry gives Bill a loan but he knows by doing this he’s taking a risk. The primary risk is Bill might not pay back his loan. In such a case Larry would lose tons of money. To avoid such an unpleasant scenario, Larry asks Bill to pay interest on his loan to make sure Larry doesn’t lose too much money if Bill defaults.
The interest is Larry’s security blanket.
The amount of interest Larry asks Bill to pay him depends upon several factors:
Bill’s credit risk: The risk the Bill is going to default
Prepayment risk: The risk that Bill is going to pay early
Interest rate risk: The risk that the amount of interest Larry receives will decline in value due factors Larry cannot control.
Larry weighs these factors and determines Bill’s interest rate. Bill pays his interest and the two live happily ever after. Not so fast…
In reality there are many layers separating Bill and Larry. Larry and Bill will probably never meet or have a beer, let alone learn one another’s identities.
So how will Larry and Bill do business? Bill and Larry work with a go between guy named Goldman Sachs.
Goldman Sachs is a credit rating agency. Sachs works with thousands of borrowers like Bill, people who need money for their mortgages, businesses who are looking for investors, the list goes on.
Sachs also keeps a huge suit case of mortgages and bank loans to sell off to people like Larry. (Larry can make money from the interest investments bring). Sachs slices the suitcase into pieces so that each piece of the suitcase consists of a mix of good credits and bad credits, low risk and high risk bank loans respectively.
This “splitting of the suitcase” divides the risk of the bad credits. Investors like Larry may purchase whichever pieces of the suitcase they choose, depending on the level of risk they wish to tolerate.
The problem arises when Sachs starts selling high risk pieces of the suitcase to investors like Larry while telling these same investors that the pieces they are purchasing are low risk.
A second problem arises when Bill begins to shop for a credit rating score. ( a good credit score for Bill means a cheaper loan!). We’ll tell you about Bill’s bilg problems tomorrow!!
Courtesy: http://michaelcorey.ntirety.com/Portals/1101/images/wbankrun.jpg
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