Ratings' Role in the Financial Crisis

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The pieces of the puzzle are falling in place, the guns seem to be smoking and people are talking about the elephant in the room.

However you want to put it, the core causes of the financial crisis are slowly but surely being revealed to the public. For this we can thank regulators, reporters and prosecutors, who would have better served the public had they shed some light on this stuff when it was actually happening.  But I suppose we were all too busy buying and flipping houses. Oh well.

The latest revelation is a doozy. It seems that New York’s Attorney General Andrew Cuomo is now investigating whether or not eight banks mislead ratings agencies in order to obtain higher ratings on mortgage-backed securities. Let’s put this into some context.

Remember during the boom times when banks were giving mortgages to just about anyone? Why were they doing this? Well, many were using those mortgages as inventory for investment mechanisms called CDOs (basically funds full of mortgages that people could buy shares of). Some of these funds were pretty safe investments, because they were filled with mortgages held by people who were likely able to pay them back. Others were filled with sub-prime mortgages, generally taken on by people with less stable incomes, and thus less safe.

Now, how could investors tell the difference between the safe and unsafe funds? Ratings agencies. Companies like Moody’s, Standard and Poor’s and Fitch all rate investment funds, and Cuomo suspects that the banks provided imprecise or misleading information to the ratings guys in order to secure higher ratings for some of these funds.

Now, why would they do that? Why would they want their investors to think they were buying shares in something more risky than it seemed?

There are two reasons:

1)    Banks and investors are always looking for ways to hedge their bets when they make an investment and it was no different with these mortgage funds. Investors were able to buy something called a ‘credit default swap’ – a type of insurance policy – for this very reason. Essentially, this is a bet that the fund is going to lose money. Some people also refer to this as a ‘short’ or ‘short position.’
2)    The banks that created these funds were also allowed to invest in them on behalf of their clients and themselves (which to me seems kind of like a conflict of interest, but what do I know?).

So this latest investigation by Cuomo suggests that banks may have been misleading these ratings agencies to improve the appearance of these investments so that certain clients could bet against the funds and thus be significantly enriched when they failed, which many ultimately did.

Here’s how The New York Times described it: “According to former employees, the agencies received information about loans from banks and then fed that data into their models. That opened the door for Wall Street to massage some ratings.  For example, a top concern of investors was that mortgage deals be underpinned by a variety of loans. Few wanted investments backed by loans from only one part of the country or handled by one mortgage servicer.  But some bankers would simply list a different servicer, even though the bonds were serviced by the same institution, and thus produce a better rating, former agency employees said. Others relabeled parts of collateralized debt obligations in two ways so they would not be recognized by the computer models as being the same, these people said.  Banks were also able to get more favorable ratings by adding a small amount of commercial real estate loans to a mix of home loans, thus making the entire pool appear safer.”

Pretty shady stuff. It's bad enough that it appears that the ratings agencies were incapable of doing their jobs, but what’s worse is that investigators have even suggested that they implicitly aided the banks by publicising their rating methodology, thus making it easier for the banks to fool them. There’s also the fact that many former ratings employees went to work for the banks, where they enjoyed steep pay increases in exchange for helping to secure good marks for some of these investment funds.

A few weeks ago in my piece A Call for Transparency on Wall Street I wrote this analogy:

“Let’s say you’re a car dealer who is selling flashy convertibles on the cheap. You’re doing a brisk business when all of a sudden you learn that these cars will likely burst into flames when they hit 10,000 miles. You don’t know for sure, but you’re pretty confident because you spoke to the guy who installed the gas tanks and you know that they were attached using Silly Putty, which you suspect is not the ideal material. Now, the right thing to do in that situation would be to stop selling those cars right away or in the very least tell the buyers about your concerns, right? Of course. Instead, however, you see an opportunity. You quietly begin to buy up all the funeral parlors in town, because you believe that very soon lots of people are going to need caskets, urns and tombstones. Someone’s going to get rich selling that stuff and it might as well be you.”

With this new information about the ratings agencies, the analogy gets worse. Now it’s as though you are purposefully attaching an explosive on a timer to the car before selling it to a family of four.

 

Check out more Wall Street vs. Main Street stories.

 

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