- Jan 15, 2013
- 3,280
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This needs to be stopped in it's tracks. Seriously if they (congress and the feds) don't reign in what these banks are doing on wrapping bad loans into good loans and selling them like they are AAA rated to investors we are going to end up with another economic crash.
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As far as financial crisis villains go, the credit rating agencies never get enough, well, credit. But now they're reminding us that even—or especially—nincompoops can blow up the global economy when you play them off against each other with the promise of a quick buck.
The history of the crash goes something like this. Lenders made (or misled people into) mortgages that couldn't be paid back. Then, with the magic of math, banks claimed that bundles of these crappy loans were actually as good as gold—or Treasury bonds—since, the story went, they wouldn't all go bad at once. That was enough for the credit rating agencies to put their top-rated, AAA stamp of approval on this financial alchemy. Which was enough for investors to gobble up all this toxic waste. Subprime bonds, after all, paid better than Treasuries, but were supposed to be just as safe.
They weren't. That's because mortgage defaults weren't uncorrelated; they were contagious. So there wasn't any safety in numbers when it came to these dodgy loans. That was bad news for the investors who had bought this junk. And for the banks that hadn't been able to sell all this junk, while leveraging themselves to the hilt. That started a run on the banks that turned into a run on every asset in the world, as fire sales made everything but government-guaranteed debt look worthless.
It wasn't bad news, though, for the credit rating agencies. They made their money rating bonds, and only rating bonds. If it turned out their ratings were garbage, and contributed to a once-in-three-generations crisis—well, oops. But thanks for all the fees! It was one part incompetence, and another part incentives. See, there's a not-entirely-unfair caricature of the credit rating agencies as the dregs of the financial world. They are, in large part, the people who couldn't get jobs on Wall Street, and they can be a bit too credulous of the people who did. (Especially when they want to go there one day).
But as dim as the credit rating agencies might be, they aren't so dim that they can't perceive their own self-interest. And that's getting paid to rate bonds. Here's why that's a problem. There are three major credit rating agencies, but Wall Street only needs one of them to rate a bond. So a bank can ask all of them what rating they would give a bond, and then go with the one that rates it highest. This "ratings shopping," of course, gives credit rating agencies good reason—i.e., their bottom lines—to give banks the ratings they want. There's no point being Cassandra if it drives you out of business.
Dodd-Frank didn't fix this, and now it's coming back. Tracy Alloway of the Financial Times reports that banks are once again asking around to get AAA ratings on dubious bonds. One way to tell is that Fitch has only "been hired for four of the 29 subprime auto ABS deals this year, after telling issuers that the vast majority of bonds did not deserve AAA ratings." Now, the good news is that the subprime auto loan market isn't nearly as big, or systemically important, as the subprime mortgage market was before the crash. But the bad news is that we haven't gotten rid of the credit rating agencies' perverse incentives to rate bonds better than they deserve just to drum up business.
It was dumb enough to create a system that encourages the credit rating agencies to take a Panglossian view of the bonds they're supposedly rating. It'd be even dumber to leave it in place after we've seen what a disaster it is.
Link to News Source
-------------------------------------------------
As far as financial crisis villains go, the credit rating agencies never get enough, well, credit. But now they're reminding us that even—or especially—nincompoops can blow up the global economy when you play them off against each other with the promise of a quick buck.
The history of the crash goes something like this. Lenders made (or misled people into) mortgages that couldn't be paid back. Then, with the magic of math, banks claimed that bundles of these crappy loans were actually as good as gold—or Treasury bonds—since, the story went, they wouldn't all go bad at once. That was enough for the credit rating agencies to put their top-rated, AAA stamp of approval on this financial alchemy. Which was enough for investors to gobble up all this toxic waste. Subprime bonds, after all, paid better than Treasuries, but were supposed to be just as safe.
They weren't. That's because mortgage defaults weren't uncorrelated; they were contagious. So there wasn't any safety in numbers when it came to these dodgy loans. That was bad news for the investors who had bought this junk. And for the banks that hadn't been able to sell all this junk, while leveraging themselves to the hilt. That started a run on the banks that turned into a run on every asset in the world, as fire sales made everything but government-guaranteed debt look worthless.
It wasn't bad news, though, for the credit rating agencies. They made their money rating bonds, and only rating bonds. If it turned out their ratings were garbage, and contributed to a once-in-three-generations crisis—well, oops. But thanks for all the fees! It was one part incompetence, and another part incentives. See, there's a not-entirely-unfair caricature of the credit rating agencies as the dregs of the financial world. They are, in large part, the people who couldn't get jobs on Wall Street, and they can be a bit too credulous of the people who did. (Especially when they want to go there one day).
But as dim as the credit rating agencies might be, they aren't so dim that they can't perceive their own self-interest. And that's getting paid to rate bonds. Here's why that's a problem. There are three major credit rating agencies, but Wall Street only needs one of them to rate a bond. So a bank can ask all of them what rating they would give a bond, and then go with the one that rates it highest. This "ratings shopping," of course, gives credit rating agencies good reason—i.e., their bottom lines—to give banks the ratings they want. There's no point being Cassandra if it drives you out of business.
Dodd-Frank didn't fix this, and now it's coming back. Tracy Alloway of the Financial Times reports that banks are once again asking around to get AAA ratings on dubious bonds. One way to tell is that Fitch has only "been hired for four of the 29 subprime auto ABS deals this year, after telling issuers that the vast majority of bonds did not deserve AAA ratings." Now, the good news is that the subprime auto loan market isn't nearly as big, or systemically important, as the subprime mortgage market was before the crash. But the bad news is that we haven't gotten rid of the credit rating agencies' perverse incentives to rate bonds better than they deserve just to drum up business.
It was dumb enough to create a system that encourages the credit rating agencies to take a Panglossian view of the bonds they're supposedly rating. It'd be even dumber to leave it in place after we've seen what a disaster it is.
Link to News Source
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