You may have heard Warren Buffett has said that he has no problem with the Goldman Sachs deal that has resulted in charges of client misrepresentation by the Security and Exchange Commission (and is being considered for criminal charges by the Justice Department). As discussed in a previous article, I agree. If not the banks, than who is most responsible for the financial meltdown?
1. The Players
First, there were the "Quants," the quantitative analysts, fresh from Ivy League graduate schools, who prepared studies showing the extreme unlikelihood of all regions of the US housing market dropping in value at the same time. As these were academically gifted young people with virtually no practical experience, I hesitate to lay blame here.
The Quants' Bosses
It started at JP Morgan. The bosses, seasoned professionals, read the analysis, looked at the commercial banks' and thrifts' mortgage profits, and decided to get into the business. The big question is, "Did they understand that the increase in demand that would result from broadening the real estate market would result in a crash?" While the answer to this question is unknowable, there are two issues that may point to the truth.
The first, is the recent "Internet bubble." Anyone could have seen that the amount of money that was invested in Internet stocks would have pushed their valuation to ridiculous levels. Surely, an analogous investment in the real estate market would do the same.
The second, is the fact that the risk to increasing the number of real estate owners was mitigated by selling that risk to investors, instead of holding those investments on their books.
Once JP Morgan entered the real estate business, it had to offer terms that would be more attractive to borrowers than commercial banks and thrifts. So, underwriting standards were decreased. So what if you didn't technically qualify for a mortgage? A rising real estate market would allow you to sell your property at a profit, and a low "teaser" rate would result in low initial payments. After five years, you'd be making more money at your job, wouldn't you? Then you could afford the payments.
For banks and thrifts to compete, they, too, must lower their underwriting standards, or risk losing their loan portfolios to those banks that offered better refinancing opportunities.
So, we're off to the races.
The fact that borrowers were not required to prove their income did not force them to lie on applications. Even if the borrowing terms were difficult to understand, people who earned $50,000 knew they could not afford a $500,000 house.
A lie is a lie. Lies have consequences, and I am not in the camp that says, "Poor little borrowers didn't know what they were doing."
I don't think people are that stupid.
The Rating Agencies
Rating agencies are paid by the companies that generate the securities that they rate. That is inherently insane.
If I have a security I want to sell to the general public and it's inherently risky, it is the job of the rating agencies to say "That is risky."
The problem is, if one agency declined to rate the security as "not risky," all the issuer had to do is take it to another and say, "Here's my fee. See if you can rate this as 'not risky'." And they did.
Packages of loans, geographically diversified in the US were sold to the general public as AAA - the same rating given to ultra-safe US Treasuries. "Widows and orphans" could safely buy them. Why? Because, even if the underwriting standards were lax, there was good evidence provided by the Quants, verified by the Quants' Bosses (who paid big, fat fees for safe ratings), that a majority of the loans would be good, even if there were regional difficulties at times.
2. Common Thread
If the Quants hadn't come up with the studies about the general safety of the US mortgage market, someone would have figured it out. Maybe the Quants' bosses would have done it themselves, as they saw quarter after quarter of real estate lenders' profits.
Some percentage of borrowers have always lied on mortgage applications. Underwriters catch some, but not all of them, but the number that squeak through the system were never significant.
But, this bubble could never have grown unless the issuers of laxly underwritten mortgages could have sold them to a "greater fool." If they'd kept these mortgages on their books, the banks who lent the money would have had to acknowledge the losses.
That leaves the rating agencies.
3. The Rating Agency Issue
There is no excuse for the ratings agencies giving AAA rating to risky securities. Taking money to do so is effectively the same as taking a bribe.
Ratings agencies are charged with the responsibility of analyzing underlying securities and giving the public an easily understood way to know the level of risk they have. This is the one place where, "I didn't know" isn't an excuse. Maybe the Quants didn't know. Maybe the Quants' Bosses didn't know. Maybe the banks didn't know.
But the ratings agencies can't claim stupidity. Rating securities is their reason for existing. If they can't do that, they don't deserve to exist.
Maybe the Quants should have known. Probably the Quants bosses should have known. Likely the banks should have know. The borrowers should not have lied. But, most definitely, the ratings agencies should have known.
So, the next time you hear that a security is rated AAA, what will you think?
It's time to hold the ratings agencies' feet to the fire. Either rate securities by using generally accepted accounting principals or rename yourselves as, "Bribe Takers."
Perhaps a little something in this regard should be passed in Financial Regulatory Reform. And, if it isn't, I wonder.
Will it be because someone has been paid to ignore it?