High-risk and below high-risk investment grade securities in the current financial crisis

Running Head: HIGH-RISK AND BELOW HIGH-RISK INVESTMENT GRADE SECURITIES IN THE CURRENT FINANCIAL CRISIS

High-risk and below high-risk investment grade securities in the current financial crisis

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Introduction

While examining the issue of the financial crisis the role of high-risk and below high-risk investment grading comes into perspective since such affects the behavior of investors in an economy. It should be noted from the very beginning that investors heavily rely on statistics given by rating agencies in making decisions on investments. As such, security-grading agencies play an important role in investing.

In the United States, it emerged that there was a case of highly rated securities being backed by noxious mortgages (Mayer, Pence and Sherlund, 2009). The rating agencies were using inadequate and insufficient data in rating the investments. At the same time, they stand accused of using out of date models in computing the ranks. After reworking on the models and fixing the issue, the rating agencies failed to guide the market for one year. Come the year 2007, the rating agencies downgraded several hundreds of mortgage-backed securities and in the process sparked the financial downturn. In precise terms, the massive downgrading of the securities, which were initially rated as AAA, sent shock waves into the investment industry (Shanley, 2010). Two factors emerge based on this synopsis, at first, the rating agencies erred in giving false confidence by rating some securities as AAA when indeed that was not the case, secondly, the rating agencies even made a bigger error by irresponsibly downgrading the formerly rated AAA investments in a huff. This perhaps underscores the connection between high-risk and below high-risk investment grading in reference to the credit crunch.

The United States’ two largest credit rating agencies, the Moody and the Standard & Poor come into perspective. The two agencies take blame for using models, which could not accurately predict high rates in reference to home loans like Option ARM, subprime, interest on mortgages, which coincidentally made the larger part of the market. The rating personnel acted based on uncertain criteria, unclear guidance, and the complexity surrounding the investment sector (Merkel, 2010).

Higher credit risk presented by mortgage fraud, poor quality loans, and laxity in lending standards. The sudden nature of degrading the high-risk investments was a major contributor towards the collapse of secondary markets. For instance, the Collateralized Debt Obligations and the subprime Residential Mortgage Backed Securities meant investors were left in possession of unmarketable securities. Such an occurrence had only one possible outcome, the precipitation of the credit crunch (Stanyer and Dimson, 2010).

The fall of housing prices over the subprime meltdown coincided with a severe drop in the value of subprime residential mortgage property beyond the principal values. This meant that collateral provision by the structured securities could not be sustained by the mortgages (Brunnermeier, 2009). However, rating agencies did not capture such a discrepancy.

A poor rating results to substantial effects to concerned entities regarding investment. Such a rating is detrimental to the issuer of a security. Based on this, the companies, which issue securities, become under intense pressure to strike cordial relations with the rating agencies. The presence of a limited number of rating agencies further compounds the problem. Based on this realization, there is a possibility of conflict of interest and one cannot rule out an aspect of collusion to present a faked rating to the public. This may also explain why the ratings were not accurately given in the first place. However, if ratings are genuinely given, the emergence that some companies are rated as high-risk ventures, there is every reason to suggest that investors will be unwilling to invest in such companies’ securities. Lending entities may also refuse, or rather become reluctant in advancing credit to such companies based on the high-risk nature of the kind of investment. The fact that the rating companies had given false confidence initially and they hastily revised them underscores the contribution made by high-risk and below high-risk rating. It should be noted that after rejecting to advance credit to high-risk graded ventures, the financial market becomes constrained. The haste nature of the grading companies’ move to downgrade further worsened the situation (Bouchentouf, Dolan, Duarte et al. 2008).

The controversy in investing the two types of security comes into the fore when viewed in reference to the expected returns. A high-risk grade security promises a huge return when compared to a below high-risk security. However, the bigger issue rests on the potential to loose out on an entire investment. While the below high-risk is relatively safer, the other is potentially risky. This affects the potency of raising capital.  

Another dimension worthy exploring rests on the fact that below high-risk graded investments are considered attractive investment options for potential investors. Even lending institutions are more receptive to such business ventures. However, the rating agencies had fumbled by presenting an inaccurate picture regarding the grading of high-risk and below high-risk investments. This implies that even if an investment were truly below high-risk in reference to grading, such would not pass convincingly. This is especially held in view of the realization of the inadequacies of the rating agencies. Put in pedestrian terms, the trust had already been lost. While in normal circumstances the below high-risk graded investment could attract financing, this position could not hold afterwards. This meant there was a host of difficulties in raising funds both in reference to high-risk and below high-risk graded investments (Shanley, 2010).

According to Merkel, (2010), it should be noted that there is another pitfall associated with high-risk investments. This follows from the idea that high-risk investments in a poor economy may lead to a rise in interest rates. Rising interest rates may worsen the activities in a financial market as the cost of accessing capital shoots up. This is further augmented by the inverse relationship, which characterises securities and interest rates. Rising interest rates has the net effect of pushing down the prices of securities. Based on this account, it is discernable that high-risk investments play a detrimental role by destabilising the financial markets.

Conclusion

The grading on investments securities is critical. While the grading itself cannot cause a financial meltdown, if done unprofessionally and without due care, there are chances such could play a huge role in triggering a financial crisis as this paper establishes. The errors in grading of the investments were partly attributable to the sinking of the financial markets. However, the mass downgrading of the capital markets presented the sad turn of events. This notwithstanding, high-risk graded investments tend to scare away potential investors, on the other hand, below high-risk graded securities form an attractive venture and consequently facilitate the raising of capital. Nevertheless, the role of grading or rating agencies is equally critical based on the realization presented in this paper.

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