Every profession has its own vocabulary and the field of finance and investment securities is no exception. Some words enlighten while others just sound good and do not really explain the events very well. Take the word bubble, what does bubble really mean. A bubble occurs when a market gets overpriced. Sometimes referred to as the greater fool theory. That is when someone will come along and pay a higher price for a product until there is no one left that will pay the higher price and then the price starts to come down, down, down. At that point the bubble is said to have burst. Is that what happened in the recent mortgage bubble or meltdown?
An article in this past Sunday’s New York Times Magazine titled Triple-A Failure: How Moody’s and other credit rating agencies licensed the abuses that created the housing bubble - and bust by Roger Lowenstein is excellently written and researched. Anyone that wants to examine a bubble under the microscope needs to read this article. Unfortunately, the people in Washington that represent the people, that should read this article every morning when they get up and every night before they lay down, will probably not read this article at all.
The bottom line is that the rating agencies did not do the job they were paid to do. Why did they not do their job? Because they had a conflict of interest. The conflict is the age old conflict of interest. Take the money and run, or turn down the business when the requirements for the triple-A rating that the underwriter is looking to receive are not there. Who in America turns down business when it comes knocking? Unfortunately, for the rest of us out there, not involved in the mortgage business, the greed of the rating agencies kept the bubble going for longer than it ever should have lasted. In fact, in my opinion, without the rating agencies compliance, no bubble would have occurred.
The three rating agencies, as they are called, hold a special place in the construction of a mortgage bond. While not a government agency, but as a privately or publicly owned corporation, the rating agency does for bonds what the Food and Drug Administration (FDA) does for drugs. (I will leave food out of this to keep it simple.) When a drug company has a new drug, they take it to the FDA. The FDA tells the drug company to set up a series of tests to prove that the new drug does what it says it is going to do without hurting the individual taking the drug. The point of the tests is to prove efficacy. After the tests are completed the FDA either approves or does not approve the new drug. The rating agencies by giving the triple-A rating to a new batch of mortgage bonds is in essence giving the bond efficacy or at least the good housekeeping seal of approval. Without a bond rating, the task of selling an un-rated mortgage bond issue of several millions of dollars, would be nearly impossible.
At this point, the leaders in Washington need to make a forensic examination of the mortgage bond bubble so they can fully understand where the weakest link in the manufacture of the mortgage bond and the resulting crisis took place. Again, without the rating agencies going along and giving out the triple-A rating on new mortgage bonds, that never should have received their triple-A rating, this housing bubble never gets off the ground.
Wall Street has a choice. Change the way the rating agencies are compensated? Bring on a layer of new Federal regulation to oversee the rating agencies? Remove the rating agency function from the private sector? Or, shoot the head of each rating agency the next time there is a mortgage bubble caused by excessively poor work by the rating agencies? I am kidding about the last suggestion, but some one needs to be held responsible for not doing their job right. We can not expect the SEC to take responsibility for the rating agencies, or can we?
One more thing, and this is of a more technical nature. The rating agencies need to improve the mathematical constructs they use to access risk. This is no easy task. Models are developed based on past information and do not by definition lend themselves to access future probability. In other words, it is difficult to drive a car by looking in the rear view mirror when going forward. That is why tough honest research must be done before the mathematics are applied. If the foundations of the rating process are compromised, the best mathematical constructions will not save the markets from another bubble. Stay tuned.
Foot note. The stamp painting was done before 1992 and is titled Federal Home Loan Bank Commemorative. The subject was a previous housing bubble.
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2 comments:
Have we, in the last two hundred years or so, gone through this before?
Oh yes, and a lot worse. There was a time when they called them economic panics. There was no central bank and the recovery time was much much longer. In modern times,(since the Great Depression) the Fed and the government have acted to reduce pain and suffering, and get the engine back on track as soon as possible. These checks that are going out is like the train engineer throwing sand on the tracks to get traction. The only problem is that Bush is throwing too much bullshit and not enough sand.
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