Riddles Wrapped in Mysteries Inside Enigmas

by Bruce Carruthers on March 31, 2008

In the greatest sea battle of World War I, British Admiral David Beatty watched with uncomprehending dismay as his battlecruisers got blown out of the water, and famously remarked that: “… there seems to be something wrong with our bloody ships today.” Ninety years after Jutland, there seems to be something wrong with our bloody financial system. A big reputable investment bank like Bear, Stearns wasn’t supposed to get into such trouble that it had to be bailed out by the Federal Reserve before it blew up. One of the legacies of the last systemic American financial crisis, in the 1930s, was a regulatory system intended to ensure greater transparency for investors, some measure of confidence for bank depositors, and prudential requirements for financial institutions. Recent events suggest that this system is no longer adequate to the task. The savings-and-loan crisis of the 1980s could have slowed down the push to deregulate, but in the 1990s the Asian Financial Crisis provided a moment for self-congratulatory triumphalism about the superiority of Anglo-Saxon finance and the perils of crony capitalism. With rigorous accounting standards, regulatory oversight, and a quantitatively-based credit culture that kept lenders honest, surely the U.S. wouldn’t be vulnerable to the real estate bubbles that plagued Indonesian, Thai and South Korean banks. Or so we fervently hoped. Thus, financial deregulation and innovation proceeded apace. Today’s sub-prime mortgage crisis wasn’t supposed to happen, and now investors are haunted by the fear that financial portfolios are filled with near-worthless paper. And the baleful effects of the credit crunch are now felt widely by both individuals and firms.

There seems to be plenty of blame to spread around. Whether the finger-pointing will result in constructive action remains to be seen, but some serious ideas are being entertained. Several weeks ago, Congressman Barney Frank proposed to expand and consolidate regulation of all financial institutions, and of necessity the Federal Reserve System had to assume responsibility for investment as well as commercial banks when it orchestrated the Bear Stearns rescue. Today (Monday), Treasury Secretary Paulson is scheduled to present the administration’s own plan for regulatory consolidation (the executive summary is on the Washington Post website), and it is already getting criticized for being broad but too shallow. The several-decades-long deregulatory shift appears set to pause and even reverse itself. This crisis has produced a lot of financial grief, to be sure, but it has also created a political opportunity to do something.

One persistent problem is that financial markets are riddled by what economists term “information asymmetries.” Life is relatively simple when all market participants know what is going on, but knowledge and ignorance are very unevenly distributed when it comes to financial contracts, institutions, and instruments. Someone knew that Bear Stearns was getting deep into trouble, but it sure wasn’t me. And if the company’s share price on the New York stock exchange was any indicator, I had plenty of company (including many Bear employees). More generally, borrowers know more than lenders about their willingness and capacity to repay a loan. Such asymmetries are not easily redressed since lenders recognize that borrowers have an interest in making themselves look good enough to secure the loan. A financial market is really a market for lemons (as George Akerlof termed them).

There are a couple of general ways to deal with the problem of uncertainty. One involves acquiring more information. Another entails sharing the risks and spreading them around. Let’s look at the first strategy for now. Responding to “roaring twenties” stock market speculation and then the crash of 1929, federal legislation passed in 1934 required public companies to file regular audited reports, among other things, and created the Securities and Exchange Commission to oversee stock exchanges and enforce the new legislation. In short, companies were legally required to provide more detailed and credible information to shareholders and would-be investors. This measure was put in place because companies had been either unwilling or unable to do so without the threat of legal sanction, and so many investors went into the stock market knowing very little about what they were actually getting into. Mandating more information certainly helped, but the Enron experience of 2000-2001 showed that Generally Accepted Accounting Principles (GAAP) remain flexible enough to accommodate some highly creative accounting, and that the independence of the so-called “independent auditors” could be thoroughly subverted. A recent report (PDF) by court examiner Michael Missal on the bankruptcy of New Century Financial Corp., one of the biggest subprime mortgage originators, reminds us that the Enron episode wasn’t a one-time anomaly.

Regardless of their flaws, disclosure requirements are not the only way to generate more information and reduce uncertainty. There are private sources of information that investors can look to: the rating agencies. These have been operating in Wall Street for many decades and their judgments about the credit-worthiness of corporate borrowers have become enormously consequential. Although they now offer many services, their original business involved rating bonds. A corporation seeking to borrow money would try to sell bonds. As borrowers, however, corporations faced the problem of how to convey information about their own credit-worthiness to would-be lenders (i.e., bond buyers). This is where the rating agencies got involved, acting as independent third-parties who could offer a disinterested assessment of the borrower’s true financial situation and future prospects. This assessment came in the form of a bond rating. The highest rating was given to the most credit-worthy borrower, and entitled it to borrow at lower interest rates. Less credit-worthy borrowers would get lower ratings, and had to pay more for the money they borrowed. Borrowers understood that a good rating made a big difference for the cost of borrowing, so it was best to keep the rating agencies happy.

The oldest and best-known rating agencies are Standard and Poor’s, and Moody’s. Their long-term ratings are given as ordinal categories with, for example, “AAA” as the highest rating (for S & P), “D” as the lowest, and with “A”, “BBB,” and “BB” as some of the intermediate categories. Originally, the rating agencies made money by selling their information to clients, but now it is the firms that wish to be rated who must pay the rating agency for the privilege. The rating agencies consider themselves to be in the business of providing credible, accurate opinions about risk. They have been in operation long enough to have fine-tuned their information-gathering procedures, and as for-profit firms their products seem to have passed the market test. The big two rating agencies did not invent their methods out of thin air, but built on those previously developed in the realm of trade credit evaluation. Even before John Moody or Henry Varnum Poor rated railway bonds, the precursors of Dun and Bradstreet were busy providing assessments of creditworthiness for trade creditors (Rowena Olegario’s A Culture of Credit, Harvard University Press 2006, provides a useful historical account of the rise of Dun and Bradstreet).

Rating agencies rate many securities and instruments, offering their judgments about the creditworthiness of foreign and domestic corporations, municipalities, sovereign governments, and even some of the newer acronymic instruments that vex mortgage markets today (ABS’s, CDO’s, RMBS’s, etc). Their ratings are used widely, and have been absorbed into banking and insurance regulations. In some ways, their ubiquity and taken-for-grantedness has helped make today’s crisis particularly unnerving, for it has become clear that some serious problems were buried beneath the surface of many highly rated instruments. What looked like carefully-calibrated risks proved instead to be very unpleasant surprises.

What makes these gatekeepers of the financial market so curious is that as important as they are, little is known about how they work (one starting point is Timothy Sinclair’s The New Masters of Capital: American Bond Rating Agencies and the Politics of Creditworthiness, Cornell University Press 2005). They may contribute to the transparency of the global marketplace, but their own inner workings are notoriously opaque. This is, of course, by design. Rating agencies wouldn’t matter if others could easily recreate or reverse-engineer the ratings they produce. What is also striking is the scant public oversight over the rating agencies. They were given special status by the SEC as Nationally Recognized Statistical Rating Organizations (NRSRO), but until recently it was unclear how they qualified. Only in 2007 did the SEC finally specify (PDF) by what criteria they granted NRSRO status.

Perhaps it is no wonder that there seems to be something wrong with our financial system. An irrationally exuberant real estate bubble was clearly a problem, but it was compounded by uncertainty about real estate values and the true worth of financial instruments secured by real estate. Although everyone recognized the need for more information, the private institutions that we rely upon to shed light on financial uncertainties are themselves rather unknown. We took easy comfort in AAA ratings without knowing enough about where such ratings came from, and without any public oversight or accountability to help resolve the mystery. We thought we were getting “credible, accurate opinions,” but instead we received opinions that sprang from the rating agencies like pronouncements from the oracle at Delphi. More transparency is a good thing, but it needs to start with those who ostensibly produce it: the rating agencies.

{ 43 comments }

1

Robin Green 03.31.08 at 3:46 pm

Suppose the rating agencies were pursuing short-term profits at the expense of their future reputations and long-term profits. If so, I have a very basic question.

The law requires executives to act in the interests of shareholders – but how does the law says the interests of short-term investors and long-term investors should be balanced?

It seems to me that there are lots of ways for decision makers to game the system and line their own pockets at the expense of shareholders and customers, without really getting called on it, either because what they are doing is so complicated, or because it’s hard to pin down responsibility.

2

Stuart 03.31.08 at 4:06 pm

Isn’t it the case that the AAA rated tranches of CDOs have (are) mostly been paid off successfully – it is the intermediate tranches that were supposed to be still supposedly pretty safe bets (A, BBB) that are likely to be lose a lot of value unexpectedly. There was an article somewhere (I forget where) that was giving an example of one of the worst CDO issues from a major player (a Goldman Sachs issue consisting of all second mortgages, self assessed, and only 1% average deposit) where the AAA first tranch had was in no danger despite how bad the issue was.

3

HH 03.31.08 at 4:06 pm

Everyone is searching for structural remedies when the root cause is cultural decadence. Do you not think Argentina, Italy, or Brazil have financial risk rating agencies? American securities markets flourished because corruption was held in check by responsible regulators. Starting with Reagan and culminating with Bush, the untouchables were taken out. Lost in the excitement over the Fed’s desperate recent moves is the recognition that the SEC has effectively ceased to exist as a functioning reulatory agency, thanks to a series of do-nothing Bush appointees.

Structural defects can be remedied quickly. When national character decays, it is the work of decades to restore it. Look around you and decide which malady we suffer from. Look at the military, the courts, the auto industry, the drug compaines, and the media business. Dishonesty reigns, and thus the search for structural remedies is futile.

4

Stuart 03.31.08 at 4:12 pm

I would suggest the biggest problem in the US is the ubiquity of political corruption – not so long ago in the UK it was front page news for weeks that some MPs had take a thousand or two in bribes. In the US it is an expected part of the process for them to take millions every year, and any time a particularly egregious example of graft comes to surface half the population will ignore it, claiming it to be ‘partisan point scoring’ rather than a fundamental breakdown of just governance.

5

lemuel pitkin 03.31.08 at 4:17 pm

Shorter hh: “For God’s sake, let us sit upon the ground/And tell sad stories of the death of kings.”

6

lemuel pitkin 03.31.08 at 4:29 pm

Bruce-

A bit of advice — three five hundred word posts will get far, far more (and more attentive) readers than one 1,500 word one.

Another advantage of this is that you can post more frequeently — compared with otehr formats, blogs place a very high premium on frequent updates as well as on brevity.

I think you’ll have much more satisfying exchanges here — and we’ll learn more from you — if you break your future contributions into smaller pieces.

7

HH 03.31.08 at 4:30 pm

For God’s sake, let us sit upon the ground/And tell sad stories of the death of kings.

Shorter Lemuel pitkin: “Let me look for my lost keys under the street lamp, because I can see better there.”

8

shteve 03.31.08 at 4:31 pm

Oooh, I get all sweaty when someone calls on the government to “do something” …

I’ve read that Paulson’s latest plan on reform of regulation was intended in its original draft as the next phase of deregulation! The system becomes too complex to make any sense. What about derivatives contracts? Hardly boiler plate stuff (or too risky to assume so), but they can consist of thousands of pages of legalese – simply not intended to be understood. And this is what regulators are supposed to get a handle on? They’re like midgets caught in a stampeding herd. Impossible.

Why doesn’t the government just do nothing? The banks and their investors go down, along with residential and commercial real estate across the world. Then real indicators of what’s going on in the market – bonds and currencies – tell the rest of us where the good investments are left.

9

Bruce Wilder 03.31.08 at 4:46 pm

A lot of people think the concerns about Bear, Stearns as a threat to the system had to do not only with the quality of the mortgage paper it held, but also with its role as a nexus of derivatives exchange. No one appears to understand the implications of the derivatives market in credit default swaps and the like. This is partly because there is no actual institutionalized “market” in derivatives.

You will know when people are getting serious about reform proposals, when they start talking about creating a clearinghouse/registry for credit default swaps. A clearinghouse would create a window on this world and a point of regulatory leverage.

10

Bruce Wilder 03.31.08 at 4:52 pm

shteve: “Why doesn’t the government just do nothing?”

Because the deflationary implications are too difficult to anticipate and compensate for. The sudden devaluation or disappearance of large chunks of the financial securities in circulation is not unlike a sudden change in what used to be called the money supply. It can leave the general economy at a very bad equilibrium of investment and employment, where investments cannot be made to support economic growth and full employment of available resources.

11

Righteous Bubba 03.31.08 at 4:55 pm

Or shorter for shteve: there are many living breathing people attached to these numbers.

12

lemuel pitkin 03.31.08 at 5:06 pm

“Let me look for my lost keys under the street lamp, because I can see better there.”

Well, the thing is, there isn’t just one set of keys. There are lots of them, more or less likely to open more or less useful doors. So it *does* make more sense to look under the streetlamp.

13

Maurice Meilleur 03.31.08 at 5:07 pm

Shteve:

“Why doesn’t the government just do nothing”, you ask, and let “real indicators of what’s going on in the market – bonds and currencies – tell the rest of us where the good investments are left”?

The answer is that it’s hard for people to locate those good investments from inside refrigerator boxes, which is where a not insignificant number of people would be living if the financial system collapses. And where, pray tell, would people get the money to invest if they lose their homes and their jobs, even if they could find out where to invest it?

You see, that’s the hell of it: banks and mortgage companies are holding us hostage with our own livelihoods.

14

Ginger Yellow 03.31.08 at 5:28 pm

Rating agencies wouldn’t matter if others could easily recreate or reverse-engineer the ratings they produce.

At least with regards to structured products in established asset classes (RMBS, credit cards, straightforward CDO structures), people can reverse engineer the ratings easily. The methodologies are published on the agencies’ websites. Fitch even has a tool for RMBS where you can change some of the assumptions (the proportion of increased defaults for interest only loans, for example) and see what it would do to the rating of a deal.

15

HH 03.31.08 at 5:40 pm

Well, the thing is, there isn’t just one set of keys.

To stay competitive in the extension of the metaphor, I must point out that the missing key turns on the streetlamps. As of today, Paulson is refusing to introduce additional regulatory structure, instead recommending a reshuffling of the existing regulator org charts. (See (a href=”http://www.nytimes.com/2008/03/31/opinion/31krugman.html?em&ex=1207108800&en=af90d83dd12f39b9&ei=5087″>Krugman’s NYT column.) So the cultural corruption is preventing the structural reform, and thus it is the unavoidable obstacle we continue to try to avoid.

16

lemuel pitkin 03.31.08 at 6:00 pm

the cultural corruption is preventing the structural reform

And structural weaknesses are perpetuating the corrupt culture. That’s dialectics.

More generally, the point is that societies are extraordinarily complex — the most complex things we know of, probably. While we can trace out some connections and lines of causality, there is an enormour amount we’re uncertain of. Under the circumstances, claiming that one particular piece is *the* key is foolish, and owrse, counterproductive, since it leads us to think that our inability to solve one problem means we should give up on other important problems that we very well could solve.

Remember: Those who say that nothing *can* be done are, consciously or unconsciously, supporting those who don’t *want* anything to be done. What better defense of the Bush administration than that their crimes and failures are just the inevitable result of America’s corrupt culture? Careful which side you’re placing yourself on, hh.

17

mq 03.31.08 at 6:05 pm

I don’t think hh was saying that nothing can be done. Culture and law/regulation exist in a complex and mutually supportive tension, that’s dialectics as you say, and all he was doing was bringing attention to the culture half.

When the system allows real structural change to take place, and enforces it, that will be a sign that the culture is changing for the better.

18

Grand Moff Texan 03.31.08 at 6:08 pm

With rigorous accounting standards, regulatory oversight, and a quantitatively-based credit culture that kept lenders honest, surely the U.S. wouldn’t be vulnerable to the real estate bubbles that plagued Indonesian, Thai and South Korean banks.

Well, there was some action initiated at the state level, but it was blocked by the Bush administration, using a little-known power that dates to the civil war. I blogged about it here in an unremarkable bit of cutting and pasting, but I haven’t seen much about it since.

And yes, this bit is only part of the problem, but I was astounded to find that the mess wasn’t just something we blundered into, the result of taking the rhetoric of anarcho-capitalism seriously, which is foolish. No, this was policy. It’s less like a screw up and more like a scam.
.

19

Detlef 03.31.08 at 6:46 pm

Stuart wrote:

Isn’t it the case that the AAA rated tranches of CDOs have (are) mostly been paid off successfully – it is the intermediate tranches that were supposed to be still supposedly pretty safe bets (A, BBB) that are likely to be lose a lot of value unexpectedly.

Seems to depend on the mortgages (prime, Alt-A, ARM, fixed rate, date issued etc.).
WaMu Alt-A Pool Revisited

“22.69% of a pool that was 92.6% rated AAA is 60 days delinquent or worse. 3.56% of that pool is REO. That’s an amazing performance for an AAA pool whose issue date was May, 2007.”

20

HH 03.31.08 at 6:52 pm

mq:

Of course I don’t oppose structural reform. It’s just that I can’t grasp the good faith assumptions that remain in play after almost eight years of deliberate sabotaging of the existing regulatory infrastructure. Krugman ran a photo on his blog of a bunch of Bush regulatory officials posing for a picture holding hedge clippers to a stack of paperwork, celebrating a “streamlining” of regulations.

Until we call these people the corrupt fools they are, and turn them out of office, structural reform is just a conversational placebo. It will take about a decade to flush the remaining knaves out of all the institutions they invaded during the Reagan/Bush “movement conservative” integrity collapse – if it is even possible. The sooner the purge begins, the better.

21

Kathleen 03.31.08 at 7:25 pm

Wait wait — did I understand you correctly to say that the firms receiving the ratings paid the ratings agency to provide them?

Why is it then surprising that the ratings agencies were providing unwarrantedly sunshiney ratings? It doesn’t seem to me that the key issue in that case is that their methods were opaque but that he who was paying the piper was calling the tune.

Please correct me if I misunderstand what you were saying, but if I understood it correctly, it seems like a really basic “well, that’s a hell of a way to run a railroad” kind of problem.

22

Righteous Bubba 03.31.08 at 7:42 pm

Wait wait—did I understand you correctly to say that the firms receiving the ratings paid the ratings agency to provide them?

This shouldn’t be a surprise in that you can pay X firm to audit your books or inspect your house (neither of which is a foolproof set-up either).

23

Kathleen 03.31.08 at 7:48 pm

House inspections upon purchase are generally paid for by the buyer, not the seller — for these reasons. As for accounting, well, yeah — if I understand B. Carruthers’ post correctly, this looks like a problem similar to the ones wrought by the repeal of Glass-Steagall.

It IS a surprise that one would expect a system run in such a way to produce anything but bad outcomes.

24

Walt 03.31.08 at 7:52 pm

You understand completely correctly, kathleen. On top of that, the ratings agencies are in some ways a government-protected oligopoly, since ratings issued by a Nationally Recognized Statistical Rating Organization (NRSRO) have a special legal status in banking regulation.

25

shteve 03.31.08 at 7:57 pm

Or shorter for shteve: there are many living breathing people attached to these numbers.

—–

Suppose I invited that one!

And there are many living, breathing people attached to the currency. The debasing of the dollar is no less than stealing from people’s pockets. Bernanke went in front of Congress and said it only matters to Americans who travel abroad! This is what government does in order to justify itself.

Who cares about inflation when the banking system is at risk! That’s how a city trader rounded off his argument with me over this crisis. Sheesh!

I understand the argument about deflation, but this bizarre effort to keep the plates spinning when the system is so obviously corrupted surely guarantees a violent outcome.

Am very worried about Washington, and wish all Americans the best.

26

woody 03.31.08 at 7:57 pm

A very clearly written primer Mr Carruthers, thank you.

@ Mr Pitkin (No. 6): What difference does it make how long a post is? This reminds me of my students asking me “how many pages is it?” when I assign extra-credit books. Anything really worth reading is exactly how long as it should be.

@kathleen (No. 21): This is also exactly how pharmaceuticals are done as well – which is why even the feeble traditional media carry stories about certain products’ ineffectiveness, dangers, etc. after they’ve been cleared by the FDA and been on the market.

Patients, like investors, must have reliable information to make decisions. Any quality government reform must incorporate this into their plans.

27

Righteous Bubba 03.31.08 at 8:15 pm

House inspections upon purchase are generally paid for by the buyer, not the seller—for these reasons.

You’re right. I should have used a more reputable example like, I dunno, car mechanics.

28

Righteous Bubba 03.31.08 at 8:16 pm

Replace “more reputable” with “better” as I have bafflegab disease.

29

Kathleen 03.31.08 at 8:34 pm

But, R.B. — in the case of an auto mechanic, first, everyone is explicitly aware that bribery is a risk of the car inspection system. If a particular shop takes bribes to hand out inspection passes and thus has a higher than normal pass rate, they will attract the notice of the authorities and be fined or prevented from continuing to provide auto inspection tags etc. No one expects that to be a system that will work on its own without checks, since yes — the people paying for the inspection want a thumbs up, not a thumbs down, and might be willing to pay extra to get it or go to a shop known to give everybody a pass. In the case of these ratings agencies, the attitude I take it was — “they are doing a great job that is great and that does not require external oversight yaaaaay!” ie, a damn stupid attitude.

Second, if you just mean — I pay an auto mechanic to fix my car, sure, but the point is it’s not in my interest to have the auto mechanic NOT tell me my brakes are out such that I die in a horrible accident. for one thing, I won’t go back again afterward, obviously, for more services. In the case of the ratings agencies, it is actually in the payer’s interest for the payee to say “wow, things are just great!” and the payer will therefore go back again and again for the same sunshiney message that enables them to sell their crappy bonds at a higher price than they warrant.

30

mq 03.31.08 at 8:34 pm

It will take about a decade to flush the remaining knaves out of all the institutions they invaded during the Reagan/Bush “movement conservative” integrity collapse

I actually don’t think this is just about movement conservatism. There were a lot of celebratory neoliberal assumptions about markets that got broad creedence across the whole political spectrum.

31

Righteous Bubba 03.31.08 at 8:38 pm

But, R.B.

Paying less attention to me makes me feel smarter.

I blame that stupid energy drink and the fingers that type dumb things when I clearly intended to type smart things.

32

Kathleen 03.31.08 at 8:55 pm

R.B. –

:)

33

HH 03.31.08 at 9:16 pm

The pessimists who predict human extinction sometime this century point to wider and wider oscillations in the consequences of human error. If you look at the size of the current US credit collapse it will be roughly a $1 trillion writeoff, as compared to $100 billion for the S&L debacle.

WWII was about four times more damaging than WWI in global fatalities, but a nuclear exchange involving even a few hundred warheads will kill a vastly greater number of people. The selfish gene has conserved traits of predation and destructive ideological problem simplification that are disastrous when coupled with the magnifying effects of global electronic and nuclear technologies. As we built increasingly powerful, unstable, and dangerous technologies, we have failed to build a better human beast, and our beastly instincts may well destroy us.

34

Bruce Carruthers 03.31.08 at 9:25 pm

I certainly appreciate the reactions to my post, and there is far more at play in your comments than I can hope to respond to. But a couple of thoughts particularly caught my eye because they raised the issue of whether regulatory reform can ever succeed if the regulatory machinery is subsequently operated by “corrupt knaves”. As many have noted, formal rules are one thing, implementation is another. If the person implementing a rule is ideologically opposed to that rule (for example, if a deregulatory zealot is put in charge of a regulatory body), then one is likely to get half-hearted, foot-dragging quasi-implementation at best, and at worst, outright subversion. Most regulations have enough flexibility and discretion built into them that an uncooperative regulator can do a really bad job, and still remain in formal compliance. It helps to have regulators who believe in the legitimacy of the regulations they are charged with implementing — it produces less knavery and corruption.

This means that the regulatory reform response to the current mess will come in two stages, if it happens at all: first, some new formal regulations or institutions will be put in place; and later on, someone will have to implement those regulations and inhabit those institutions. Both stages will matter in constituting the full regulatory response, although it is usually the first stage that gets most of the attention.

35

Ginger Yellow 03.31.08 at 10:18 pm

I think that people are missing a trick when they focus on the issuer-pay conflict of interest. It exists, sure, but conflicts also exist when investors pay, and at least issuer-pay ratings are public. The really dangerous conflict, which nobody seems to be picking up on, is that rating agencies have a vested interest in allowing/encouraging innovation in structures and products. The more ratable, and especially triple-A ratable, structures/products the more business they get, and they don’t even have to bother with grubby favouritism. It’s doubly dangerous because it bypassed the agencies’ undeniable strength – statistical analysis of historical credit performance. If the structure or product has no history, statistical analysis is useless. So they were forced to venture deeper into the world of assumptions and analsyis of factors outside their expertise, like liquidity or market value.

It was probably this conflict that led the agencies to grant triple-A ratings to products that turned out not to deserve them – CDOs of ABS (especially mezzanine ABS), SIVs, CPDOs etc.

36

Matthew Kuzma 03.31.08 at 10:22 pm

The obvious solution is a new set of ratings agencies that rate ratings agencies. That will solve the information imbalance, and if not, then certainly another layer of ratings agencies will.

Secondly, you may be using a technical definition of irrational, but as someone who was involved in the real-estate business first-hand during this period I don’t think the behavior qualified for the more general definition. Consistently lowering interest rates caused a surge of qualified buyers, driving up demand and correspondingly prices. It may have been myopic to think 15% annual appreciation was here to stay, but that’s more an example of information imbalance than irrationality.

Finally, what is your assessment of things like prosper.com?

37

Kathleen 03.31.08 at 10:52 pm

kuzma — Those
responsible for sacking the people who have just been sacked
have been sacked? Sounds a bit Montypythonesque.

I personally think these are the kinds of functions for which we the people elect a gummint, rather than wheels within wheels of private-sector guarantors of accountability, the gears of which always turn out to be a bit too greasy.

hh — I’ve heard marching around outdoors with a giant sign that says “repent the end is near” is good fun AND sometimes provides a suntan to boot. You may want to look into it.

38

HH 03.31.08 at 11:07 pm

hh—I’ve heard marching around outdoors with a giant sign that says “repent the end is near” is good fun AND sometimes provides a suntan to boot. You may want to look into it.

Repentance is called for, but also a rediscovery of serviceable old words relegated to the attic of political correctness. Words like WICKEDNESS, THEFT, LYING, and CIVIC DUTY need a good airing and reintroduction into common parlance.

What amuses me in these discussions is the resolute insistance on the invariant character of American homo economicus, as though his/her character has not deteriorated markedly since Reagan. We have gone from Great Society to Grifter Society in one generation.

39

MarkUp 03.31.08 at 11:37 pm

BC – “It helps to have regulators who believe in the legitimacy of the regulations they are charged with implementing—it produces less knavery and corruption.

This means that the regulatory reform response to the current mess will come in two stages, if it happens at all:…”

Well, the current admin was able to re-corral a whole lot of goodness in to DHS as well as revamp the Intelligence [sic] collection folks structure, so it would be unwise to wonder if it will happen, just how bad it will be. Perhaps if the ‘regulators’ had a capitalistic incentive that surpassed the revolving doors and favors, or even just saw some real punishment happen with what they do find now, they would be mo properly motivated. Remember, if they pull off Paulson’s plan right the ice trucks will be there* when needed.

40

HH 04.01.08 at 1:48 pm

The interesting sleight of hand in the Bush administration’s regulatory “response” to the credit crisis in the increase in discretion permitted to regulators acting according to vague “principles,” and the diminution of formal regulatory structure. This is exactly what a corrupt government would seek: shifting power from the strictures of explicit laws to the discretion of pliable men.

These people are shameless knaves, and because the US public has normalized dishonesty, their mischief is brazenly described as “reform.”

41

SamChevre 04.01.08 at 7:31 pm

With regard to “it helps a lot if the regulators believe in the rules”; it is worth noting that it also helps if the rules make reasonable sense (and aren’t, for example, an attempt by existing institutions to handicap new entrants, like many insurance reserving rules; or designed before secure electronic communication was normal, like many banks’ check-crediting rules.) If the rules don’t make sense, sensible people won’t believe in them; they have to be enforced either by not-sensible people, or by people who know they are stupid and will focus on paper compliance.

42

shteve 04.03.08 at 8:06 pm

To round off my “do nothing” comment (#8):

“Gentlemen, I have had men watching you for a long time and I am convinced that you have used the funds of the bank to speculate in the breadstuffs of the country. When you won, you divided the profits amongst you, and when you lost, you charged it to the bank. You tell me that if I take the deposits from the bank and annul its charter, I shall ruin ten thousand families. That may be true, gentlemen, but that is your sin! Should I let you go on, you will ruin fifty thousand families, and that would be my sin! You are a den of vipers and thieves.”

Not me – Andrew Jackson

43

Craig Johnson/ cognitorex 04.04.08 at 4:50 pm

“Leverage” An off off Wall Street Drama

“Who’s knocking on our door ?” the CFO of a huge investment bank asked.
“Why it’s the government Banking Auditor. It’s his day of the week to ask us to mark our assets to market.”
“Are we in shape for his visit?”
“Uhm, Yes and no. Sorta good news, bad news.”
“What’s the good news?”
“We’ve done the math and we figure our remaining mortgages on the books, good and bad, are worth $43 billion, so we’re okay.”
“What’s the bad news?”
“Uhm, well, nobody will buy any mortgage paper at the moment and some righteous auditors have been saying, no valid quotes, no value.”
“That’s absurd. That would mean we have negative equity.”
“Shhh! He’s leaving. Bernanke’s got him on the phone.”

_________________________

The Crooked Citizen takes a Mortgage

John and Jane, brokers, sit in their mortgage originator store front office. They spy a couple reading their window adverts.
“Come in, come in. And how are you lovely folks today?”
“Good.” “Good.”
“May we ask you if you rent or own?”
“Ah, you rent. $900 a month and it’s tight. We see.” (They huddle a moment.)
“Folks, we’ve assessed your case and our thinking is if you sign right here for a thousand a month mortgage, we’ll see that you get a quarter of a million dollars to get that home you have your eye on. How’s that?”
“Don’t you have to write down all your credit card debt?” “No. Your application looks great, just as it is.”
“And what will your mortgage and mortgage rate be at the end of the initial term? No one can say for sure but the standard operating procedure is that you come back and refinance with the new higher value of your home”. “Everybody does, just SOP, right Jane?”
“SOP, everybody does.”
“You’re curious how we get paid. Well, it comes from the lender’s part of the deal. It isn’t a lot but we get to put good folks in great homes. That’s a big reward right there.”
“All set? See ya later. You’re welcome, thank you.”
John and Jane high five, laughing!
“What a couple of con artists those two are, borrowing a quarter mil on their credit record.”

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