Lots of groups have been blamed for the recent financial crisis, including the Federal Reserve, banks, and Congress for deregulating financial institutions by repealing the Glass-Steagall Act (which separated banks that accepted deposits from investment banks). One that deserves scrutiny is the ratings agencies–Moody’s, Standard & Poors, and Fitch–that gave AAA ratings to bonds made up of subprime loans.
The ratings agencies definitely have a lot to answer for. Historically, only one in 10,000 AAA bonds defaults in an average year. So banks and other financial institutions confidently invested in AAA mortgage bonds only to see the value of those bonds fall dramatically.
Beginning around the 1980s, banks began packaging a thousand or so mortgages into one bond, known as an “asset-backed security,” and asked the ratings agencies to rate the bonds. The agencies assumed that a few mortgages would default (though no one tried to predict which ones), so the banks divided the bonds into subbonds called tranches. The lowest tranch would pay the highest interest rate, but it would evaporate if some of the mortgages (it didn’t matter which ones) defaulted. The agencies assumed no more than a certain percentage would ever default, so the highest tranch would get a triple-A rating but pay the lowest interest rate.
The first problem was that the banks learned to “game” the agencies by designing the bond to get the highest percentage of triple-A rated tranch. This was made easier because some of the ratings agencies, for transparency sake, published their risk models. For example, to maximize the size of the triple-A tranch, the average FICO score of borrowers had to be at least 615. Defaults were rare for people with FICO scores of 615 or more.
But people with FICO scores of 550 were much more likely to default. Yet a bond could get an average score of 615 if half the mortgages were 550 and the other half were 680. The result was the agencies would place 80 percent of a bond in the triple-A tranch even though half the mortgages were likely to default.
It gets worse. The banks found it easy to sell the triple-A tranches of the bonds, but not so easy to sell the tranches rated BBB or lower. So they collected those tranches into another bond, known as a collateralized debt obligation, and asked the agencies to rate that bond. Surprisingly, the agencies would give triple-A ratings to 75 percent of the bond–even in late 2006, when the housing bubble had already peaked and sales and prices were declining.
The ratings agencies made at least two fundamental mistakes. First, since the housing market had never dropped more than 5 percent in any year since the Great Depression, they assumed it never would drop. Second, and more particularly, they assumed that declines in home prices in, say, California would be offset by increases in prices somewhere else. So bonds made up of mortgages in California, Florida, Massachusetts, and Nevada were considered “diversified.” In other words, they assumed the correlation between mortgages was low; that is, just because one person defaults doesn’t mean another person will.
A number of investors figured out there were serious weaknesses in the ratings agencies’ models. As Michael Lewis describes in The Big Short, they scrutinized the mortgages behind the bonds and found tranches that were practically guaranteed to fail. Then they bet against those tranches by purchasing credit default swaps, a form of insurance.
Curiously, before 2000 it was illegal to buy such a credit default swap unless you owned the bond itself, but the Commodities Futures Modernization Act of 2000 legalized gambling in securities that you didn’t actually have an investment in. This bit of deregulation arguably worsened the economic crisis because someone ended up having to pay off the people who were shorting the housing market, but in fact there were only a handful of such investors so it made little difference.
After the crash, the ratings agencies claimed that, in giving triple-A ratings to CDOs of triple-B or lower mortgage tranches, they weren’t promising that no more than 1 in 10,000 such bonds would fail in any given year. But at the time, it sure seemed like it to investors, who had good reason to be angry at the agencies.
Why did the ratings agencies get it so wrong? Stiglitz and others claim they had a conflict of interest: the banks were paying them to give positive reviews of the bonds, so they did so. This doesn’t seem likely, since the agencies didn’t hesitate to lower the ratings in 2007 when it became obvious that their previous ratings were too high.
In What Caused the Crisis, libertarian economist Jeffrey Friedman argues that the problem is an SEC ruling giving the three ratings agencies an oligopoly. The agencies knew the banks had nowhere else to go, so they made less effort to be reliable.
The Antiplanner doesn’t buy this explanation either. In The Big Short, Lewis relates that some mortgage bears met with ratings specialists from Fitch, the smallest of the three agencies, and suggested, “If you want to make a statement–and get people to notice you–why don’t you go your own way and be the honest one?” Fitch’s people didn’t act embarrassed that they were giving good ratings to bad bonds; they acted surprised that anyone thought there was a problem with the bonds.
In other words, everyone except a few bears thought the bonds were sound. Since the banks selling the bonds were the ones paying for the ratings, if one agency consistently downgraded a particular type of bond because the agency could see a bubble and potential crash, the banks would simply give their business to other agencies.
If there is a flaw in the system, perhaps it is that the ratings agencies were paid by the sellers of the bonds, not the buyers. Since the buyers are the ones who risk losing money if the bonds fail, they would have an incentive to find a ratings agency that was more likely to be accurate.
But I am not sure that even that would have saved the day in this case. Remember that almost everybody who was anybody, from Greenspan and Bernanke on down, claimed there was no housing bubble. The reason why they were all wrong was that none of them realized that urban planners had changed housing markets by creating artificial shortages in cities housing as much as 45 percent of the nation’s families. But that’s a story for a future post.