07/16/09 New York, New York Structured financial products, from residential mortgage-backed securities (RMBSs) to collateralized debt obligations (CDOs), lay at the heart of the global credit and financial meltdown. The process of creating, rating, and selling this paper is complex. As we have learned after the fact, the rating agencies were not (as they claim) passive participants who just happened to underestimate the likelihood of future defaults. Rather, when they placed precious triple-A ratings on all sorts of mortgage-backed and related securities, they were active participants-collaborators, according to The Wall Street Journal.
The subprime paper that eventually collapsed found its way onto the balance sheets of many banks, funds, and other firms. Had “the securities initially received the risky ratings” they deserved (and many now carry), the various pension funds, trusts, and mutual funds that now own them “would have been barred by their own rules from buying them.”
Nobel laureate Joseph Stiglitz, economics professor at Columbia University, observed:
“I view the ratings agencies as one of the key culprits. They were the party that performed that alchemy that converted the securities from F-rated to A-rated. The banks could not have done what they did without the complicity of the ratings agencies.”
In 2008, the House Oversight Committee opened a probe into the role of the bond-rating agencies in the credit crisis, and Congress held a hearing on the subject, featuring a now-infamous instant message exchange: “We rate every deal,” one Standard & Poor’s analyst told another who dared to question the validity of the ratings process. “It could be structured by cows and we would rate it.”
When they are not rating bovine structured products, the rating agencies can be found belatedly downgrading junk paper into bankruptcy. In March 2009, Moody’s Investors Service came out with a new ratings list: The Bottom Rung.
“Moody’s estimates about 45% of the Bottom Rung companies will default in the next year,” The Wall Street Journal reported. Perhaps the clichZˇ about analysts is better applied to rating agencies: You don’t need them in a bull market, and you don’t want them in a bear market.
While it was the investment banks that sold the junk paper, it was the rating agencies that tarted up the bonds. It was the equivalent of putting lipstick on a pig: This paper could never have danced its way onto the laps of so many drooling buyers without the rating agencies’ imprimatur of triple-A respectability.
Yet considering the massive damage they are directly responsible for, the rating agencies have all escaped relatively unscathed. Given their key role in the crisis-were they corrupt or incompetent or both?-one might have thought an Arthur Andersen-like demise was a distinct possibility. Warren Buffett should consider himself lucky-he is the biggest shareholder of Moody’s, and is fortunate the scandal hasn’t tarnished his reputation.
Of course, none of this would really have mattered if a few hedge funds and a much larger number of institutional investors-including foreign central banks-didn’t suck up so much of this suspect paper (China evidently bought $10 billion in subprime mortgages). Through the indiscriminate use of leverage and by failing to know what they owned, the purchasers of the triple-A-rated junk paper must also shoulder some of the blame.
How did so much of the investment world manage to overlook these issues? Didn’t anyone do any due diligence? Or was it simply a case of the casinos keeping the securitization process rolling? I’ve had conversations with CDO originators and insiders, as well as money managers, who unabashedly claimed: “We knew we were buying time bombs.”
So we can rule out sheer ignorance. Rather, it appears that as long as deal fees could be generated, Wall Street kept the CDO factories running 24/7.
Talk about your misplaced compensation incentives. This is precisely the kind of self-destruction that Alan Greenspan believed was impossible in a free market system. The flaw he misunderstood was simply this: It wasn’t that the free market would prevent it from occurring; it was that relentless competitive forces would drive such firms out of business. That is what began to happen in 2008. The free market actually worked as it should-firms that managed risk poorly were demolished by market forces. The trouble was, none of the erstwhile free market advocates had the stomach to live through the creative destruction Mr. Market was serving.
That is the risk that excessive deregulation brings: We can eliminate regulations that might prevent systemic risk. However, the free market advocates whine when the market doesn’t do their bidding. Bad choices by management led to failure. That failure brought on a global recession, bankrupted over 300 US mortgage companies, and turned many of the biggest banks and investment firms into tapioca.
The firms that allowed excessive risk taking and leverage found themselves on the wrong side of the corporate version of Darwin’s laws-which was precisely where they belonged.
Several of the states with the biggest foreclosure problem today had an opportunity to confront the problem when it was much smaller. These are the states that now lead the nation in foreclosures. Their regulatory agencies had long lists of complaints brought to their attention. None acted upon them.
A 2008 expose by the Miami Herald revealed that Florida allowed thousands of ex-cons, many with criminal records for fraud, to work unlicensed as loan originators. More than half the people who wrote mortgages in Florida during that period were not subject to any criminal background check. Despite repeated pleas from industry leaders to screen them, Florida regulators refused.
And in California, attempts to regulate the many subprime mortgage lenders working in the state were beaten back, primarily by Democratic lawmakers who were protecting the then fast-growing industry.
Today, California and Florida are the nation’s leading foreclosure factories.
Then there is Arizona. When Internet real estate service Zillow began publishing online housing price estimates in the state, it received a cease and desist order from the Arizona Board of Appraisal. Zillow’s site makes it clear that its data are merely estimates and not actual appraisals. Regardless, misguided Arizona pols did not want some online firm horning in on their local business. It is no wonder Arizona is ranked fourth in the nation in terms of defaults and foreclosures listed by RealtyTrac.
The misguided deification of markets is the primary factor that led us to being a Bailout Nation. Markets can and do get it wrong-not by just a little, either; occasionally they can be wildly wrong.
Recall those two Bear Stearns hedge funds that blew up in June 2007. The S&P 500 stumbled in August 2007 at that early sign of a brewing credit crisis. But in the market’s infinite wisdom, it determined that credit wasn’t such a significant problem after all. The S&P 500 and Dow Jones Industrial Average proceeded to set all-time highs a few months later, peaking in October 2007. That they got cut in half over the next year makes one wonder why anyone would call the stock market prescient.
This was not the only time Mr. Market has managed to get things precisely wrong. There are far too many examples to enumerate here.
In the final analysis, allowing markets to set policy is inherently antidemocratic. Free people are entitled to elect a representative government, which then enacts legislation on their behalf. Those elected representatives go to Washington, D.C., to do the people’s will. If it is the people’s will to prevent testosterone-addled traders from saddling the taxpayers with trillions in losses, that is their choice.
Americans have long recognized the advantages of economic freedom. We want the markets to be relatively free to operate. However, we do not want to allow the worst of human behaviors to have free rein. Complaints about regulating markets are actually objections to proscribing the worst behaviors of the people who operate in those markets. We want markets to operate intelligently, but not run roughshod over us. Blame the radical free-market extremists who insist on replacing representative government with the so-called wisdom of markets. This has proven to be misguided.
What the actual result of market-based decision making does is to eliminate those pesky human voters from exercising their will through a representative government. Ultimately, the free-market zealots are not only antiregulation, they are antidemocracy and antirepresentative government. Taken to illogical extremes, they would create a market-based dictatorship.
One part bad philosophy, one part mob rule. That pretty much sums up the financial markets, circa 2008-2009.
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If the “free market” was allowed to be free, the blood sucking leeches JP Morgan and Goldman-Sachs would finally be pulled from the neck of the U.S. economy where they’ve been lodged for a hundred years. There is no “free market” so stop trying to blame something that doesn’t exist. The blame lies with the bought and paid for politicians.
Let’s take a quiz, shall we? In the United States…
1. What entity has given us 10,000+ pages of regulations, none of which prevented the meltdown?
A. government
B. the free market
2. What entity failed to see Bernie Madoff running a huge pyramid scheme right under its nose?
A. government
B. the free market
3. What entity altered banking regulations to permit the commingling of commercial banking activities and investment banking?
A. government
B. the free market
4. What entity created the Community Reinvestment Act, which encouraged lenders to originate higher-risk loans than they otherwise would have chosen to originate?
A. government
B. the free market
5. What entity created Fannie Mae and Freddie Mac, organizations which took risks that ordinary mortgage lenders could not?
A. government
B. the free market
6. What entity stood ready to nationalize Fannie Mae and Freddie Mac should their risky lending backfire?
A. government
B. the free market
7. What entity resisted auditing or regulating Fannie Mae and Freddie Mac?
A. government
B. the free market
8. What entity controls the money supply?
A. government
B. the free market
9. What entity has flooded the economy with money and credit and bailed out every economic crisis since 1987?
A. government
B. the free market
10. What entity determines interest rates?
A. government
B. the free market
11. What entity, from late 2001 through early 2004, cut interest rates so low that after adjusting for inflation, interest rates were actually negative?
A. government
B. the free market
12. Throughout history, what entity has acted as the best shelter for the greedy, incompetent, and the corrupt?
A. government
B. the free market
13. Which statement best describes the economy:
A. a free-market system where good business decisions are rewarded with profit and bad decisions are rewarded with failure
B. a system centrally-planned by a handful of government apparatchiks and plutocrats, wherein the competent are plundered to reward the incompetent but politically-connected
14. What entity has (to use Mr. Ritholtz’s words) “run roughshod” over the American people?
A. government
B. the free market
15. What entity is ultimately responsible for the financial meltdown?
A. government
B. the free market
You fail, Mr. Ritholtz. Please take off your “I <3 GOVERNMENT” T-shirt, put on this dunce cap, and go sit in the corner.
James R:
What entity can corrupt the government absolutely?
A. Government
B. Corporate-Financial Complex (sometimes claimed to be the ‘free market’)
Correct answer is B. Because A can only corrupt itself partially due to separation of powers.
What did happen? A or B.
Correct answer: Both A. and B. happened. Technically it’s call fascism. But let’s not get too bother with semantics.
So now what? Nothing. A. and B. are alive and well today, in charge, running things. Well, take a look at yourself!
James R – WRONG – The US Federal Reserve controls the money supply and sets interest rates and they are not a US government entity. They are a group of private banks operating independent from government.
Hey, that’s funny. The Fed is “not a U.S. government entity.” Here’s a little history. These quotes come from Wikepedia: “[U]nlike the Aldrich plan which gave controlling interest to private bankers with a small public presence, the new plan [the Federal Reserve Act] gave controlling interest to a public entity, the Federal Reserve Board…” “… opposition to the proposed reserve system plan [the Federal Reserve Act rather than the Aldrich Plan] reversed itself and came largely from the more business-friendly Republicans instead of from the more populist leaning Democrats.” This does not deny the reality of corporate capture, but with the USG having such a strong impact on money banking activities this is inevitable. And, of course, more regulation called for by Ritholtz will bring more lobbying and campaign cash, leading, as dusk leads to night, to more corporate capture.
TC: complaining about the ability of private institutions to corrupt the government is like complaining about the ability of flies to locate a giant stinking garbage dump.
The bigger government becomes—the more pies it has its grubby little fingers in—the more powerful it becomes. Power inevitably corrupts, no matter how many laws and regulations attempt to prevent it.
The Founding Fathers knew that a small and limited government was necessary to a proper and free society—but they knew all too well the inevitable tendency of government to grow in both size and power. They tried as hard as they could to chain government and bind it to the Constitution, but the American people became complacent and lost their vigilance.
And thus, some 200 years later, we find that we have surrendered many of our personal liberties (and virtually all of our economic liberties) to an ever-growing leviathan government that is strangling our economy and our freedoms with its incompetence and corruption.
“Posterity! You will never know, how much it cost the present Generation, to preserve your Freedom! I hope you will make a good Use of it. If you do not, I shall repent in Heaven, that I ever took half the Pains to preserve it.” – John Adams, April 26 1777
We should all be ashamed at what we, in our complacency, have permitted government to become.
W. MacKenzie: the Federal Reserve exists because an act of Congress chartered it. The seven members of the Federal Reserve’s Board of Governors are nominated by the President and confirmed by the Senate. And there is a giant revolving door between the Federal Reserve and government—the most recent example being Obama’s tapping Tim Geithner (the then-current President of the New York Fed) to be the new Treasury Secretary.
I’ll grant you that in theory, the Federal Reserve is a private institution. But in any practical sense, to claim that the Federal Reserve is “private” and “independent from government” is laughable.
The Federal Reserve is merely another branch of our bloated, interventionist, meddling, incompetent government. That is why my “quiz” treats it as being part of government: because it is.
Keep it up, James R. I had a number of similar thoughts while reading the Ritholtz essay, but you’ve articulated them better than I could have in all probability. Nevertheless, give Ritholtz his due. He parrots what the liberal media wants to hear, which gives him public attention, which in turn makes him money. At the end of the day, people like him are the root of the problem, just like the 535 graspers and their staff that work on Capital Hill. How do I know that? I once worked there as and later as an investment banker. Been there and seen it.
Bingo
Free markets don’t work because there are no responsible people to operate them smoothly. It’s that easy.
Lost & Found: re-read my quiz and ponder again what doesn’t work: government, or the free market.
Here’s something else for you to ponder.
Pull out your mobile phone and look at it. 30 years ago, that device was the size of a briefcase and cost thousands of dollars per month to operate. They were the playthings of the über-rich; ordinary people couldn’t possibly afford them.
But today, thanks to the competition and choice that the free market brings, mobile phones the size of a deck of cards—that have battery life and features that were the realm of science fiction 30 years ago—are given away for free.
Tell me, with a straight face, that you believe the government could have taken a technology that was once the privilege of the über-rich, improved it a thousandfold, and made it a commodity item.
(Can you not appreciate the irony that the technology you are using to dismiss the free market was not only created by the free market, but could have only been created by the free market?)
The one and only reason why you, me, and a great percentage of the world’s population don’t live lives of backbreaking, soul-crushing poverty is thanks to the free market. All of the woes that people in ignorance attribute to the free market are in fact the direct result of government interference in the free market.
If you really think that the free market doesn’t work—that we should just let the government [continue to] run the economy instead—you might as well just slit your own throat now. It’ll be faster, and less painful.
They are still trying to turn base metal into gold.
It don’t happen the nearest they can get is having somebody else who is daft enough to pay the price.
Hey, Jamie. You would have quite a case in point IF one would deem banks as being government entitities. They are not, by the way. Private market participants. And just look at the sheer numbers. Really, really big figures of wealth they have stolen and are stealing from the common man with the help of the government that supports all this bailout crap.
Wolves dressed as sheeps are them bankers, the crown of the free market. Hahahaha.
And when push comes to shove, it won’t probably help a lot when John Doe has a cell phone or is able to type a comment on the internet.
Ooops. I meant to write “entities”, of course. My apologies for the typo.
Go on, Barry. Most of the people are stuck with ignorance.