Casting Blame, Part II

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.