More Evidence the Ratings Agencies Had Nothing to Do With 2008

It was roughly fifteen years ago that some in the technology space were worried about proposed new accounting rules. The rules would require companies that compensated employees with stock options to treat those options as an expense. Since stock options were (and still are) such a big factor in tech employee compensation, the expressed fear was that the accounting rules would substantially shrink tech company earnings. But would they?

The Wall Street Journal’s Holman Jenkins called for calm. Accounting is accounting. It can’t alter a company’s underlying reality. Jenkins made plain to readers that fears of altered accounting rules were misguided; that investors wouldn’t be fooled by an expensing change. And they weren’t.

Fast forward to 2019, in its November 17th edition the Wall Street Journal reported that under new accounting rules, “airlines have emerged as surprising winners.” While most businesses would be required to treat office and storefront leases as liabilities, airlines would not have to do the same for gate and ticket counter leases. The Journal’s report showed that as a consequence of this accounting sleight-of-hand, ratings agencies were slashing the liabilities of airlines. So far, so good. No story here. Again, accounting is accounting. It cannot alter reality, and as Journal reporter Jean Eaglesham himself acknowledged as a result of the accounting changes, “nothing has changed in their financial situation.” Well, of course not.

Which is why Eaglesham’s conclusions were so puzzling. Even though the new approach to accounting for leases will in no way alter any company’s actual financial situation, Eaglesham concluded that the new accounting had made it possible for the “surprising winners” to add to their debt. Eaglesham observed that Delta had done just that, thus potentially making the airline's debt “riskier for investors.” This was an odd reach for the reporter.

Implicit in his analysis is that there exists a correlation between a change in how Delta is required to account for gate and ticket counter leases, and its ability to borrow. That’s not very likely. By Eaglesham’s own admission, Delta’s financial situation hadn’t changed one iota. Accounting is theory, it’s artistry, it’s conceptual. But it once again can’t alter reality. For Eaglesham to presume simple numerical gymnastics altered the market’s perception of Delta isn’t realistic.

Indeed, it presumes that investors base their investment decisions on the analysis of ratings agencies. That’s even less realistic. Bond raters don’t work at the agencies because they have a keen sense of the quality of debt, or the value of it. Think about it. If they had a sense of either, they’d be debt investors as opposed to debt raters. As Michael Lewis observed in The Big Short, investors view ratings agency analysts as one step above regulators. The raters can’t reshape reality, nor can they enable increased borrowing, as much as they can confirm reality. For Eaglesham to presume that ratings agencies have somehow enhanced Delta’s borrowing capacity with accounting machinations isn’t remotely realistic. Again, if raters had that kind of sway it’s safe to say they wouldn’t be working as raters.

Which brings us to 2008, or 2007-2008 if readers prefer. It really doesn’t matter. Going back to that timeframe it was said by some that faulty ratings of mortgage debt by the agencies set the stage for 2008 by tricking financial institutions into buying bad debt. No, that’s not realistic either. Nor was it.

Implicit in the notion that debt investors took their marching orders from rating agencies is that those same agencies could have averted a market correction by merely restating their Triple A analysis of debased mortgage debt in the fall of ‘08. No doubt they could have, but doing so would have been meaningless. Market perception of some of the mortgage debt changed in 2007 and 2008, and the ratings agencies weren’t going to reverse the change. Again, they can’t alter reality as much as they can confirm it. That’s why the suggestion that easy Triple A ratings of mortgage debts brought on the ’08 carnage was so hard to countenance. Rest assured investors weren’t following the lead of their intellectual juniors at Moody’s, Fitch et al.

So if readers want to incorrectly believe that bad debt caused the market crack-up in 2008, they’re free to believe as they wish. It says here the bailouts caused the crack-up, but that’s a debate for another day. For now, it should just be said that ratings agencies didn’t enable the big debt surge. It cannot be stressed enough that debt investors don’t take their cues from those who couldn’t get jobs as debt investors.

Nor does accounting sway them. Per Eaglesham’s initially correct analysis, accounting doesn’t change a company’s underlying “financial situation.” This rates repeat with the popular notion embraced by some that mark-to-market accounting “caused” 2008. Naaah. Implicit in such a view is that a theory of how to account for the value of a company’s assets tricked investors into a major correction. This isn’t a realistic view.

And if some readers doubt the above assertion, they might imagine how 2008 would have unfolded absent mark-to-market (MTM). Does anyone really think without MTM that Bear Stearns, Lehman, Citi and others sail through without trouble? The question is worth asking simply because that’s what all the hand wringing about mark-to-market presumes. Those who think accounting caused 2008 are saying that accounting, not investor acknowledgment of reality, brought on illiquidity for certain financial institutions. Not very likely.

Let’s never forget that there’s always and everywhere a market price for everything. It may not be what the asset owner wants, but there’s a market price. That in mind, and assuming MTM had created a false accounting of bank and investment bank assets, investors would have had their own view of the value of mortgage debt in 2008 that would have been different from accounting perceptions. And had it been different, mark to market or any kind of accounting wouldn’t have rendered financial institutions illiquid. Market realities would have run roughshod over accounting theory.

But they didn’t. And they didn’t because markets thankfully always have the final say. Much as expensing of options didn’t sink technology companies, neither did MTM wreck banks. Nor will a new way of expensing airline leases boost airlines’ debt capacity. When markets battle theories of how to account for reality, markets will always win.