In 2007 we had a meltdown. We had a mortgage writing and securitization system that was completely at odds with reality. For over two decades mortgage companies had been watering down the requirements needed to get a mortgage. As these standards became more lax, the integrity of these loans became more and more suspect. The reason for this was a moral hazard created by the federal government in order to get mortgages for people who could not responsibly handle the debt. It’s not a complex issue. It isn’t really that difficult to understand. And yet, we are now being told by the likes of Sen. Al Franken that the issue involved wasn’t bad loans guaranteed and governmental policy to blame, but the ones following the rules. He is attempting to rewrite history based on a series of false premises will only develop the conditions that caused the problem to happen again.
In an opinion piece at CNN.com, Franken blames the ratings agencies for the mortgage crisis. Referring to an email that suggested these mortgage writing policies were destructive, he writes, “Just two years after it was written, the house of cards that S&P helped build collapsed and roiled the global economy. And while I welcome the news that the Justice Department has launched an investigation into S&P, I imagine it will conclude what a lot of us have long known: S&P made record profits by knowingly handing out sterling credit ratings to complete junk.” ‘Wall Street rating agencies’ corrupt system.’
Let’s explore Franken’s premises. First, he starts with the presumption that rating agencies CAUSED the bad paper to be written. This is wrong on several levels. The loans weren’t being written by any of the ratings agencies. Nor were the mortgage backed securities. In fact, all ratings agencies do is try to figure out how trustworthy they are. Being most of these securities were underwritten on real property, their presumption was the loans were secured with that real estate. Even if a portion of the loans weren’t necessarily up to par, the real estate itself would back up the loan in default.
Furthermore, Franken seems to believe the ratings agencies just willy-nilly slapped high ratings on these securities with nary a thought. The real problem was, the ratings agencies didn’t just take into account that the loans were secured with real property but that the federal government was an unsigned guarantor of the paper. Most of these loans were funneled through Fannie Mae and Freddie Mac, two government sponsored entities that had the fidelity of the nation’s credit to back them up.
The ratings agencies are just that, reporters on the reliability of the paper. Backed by both real property and the full faith and credit of the nation, the ratings agencies came to an unfortunate conclusion; the mortgage backed securities were very safe.
Franken’s second flawed premise is the market as being an open and free one. The federal government has been making arbitrary and capricious rules for years creating the moral hazard of a government guided welfare/mortgage policy. Furthermore, they made a system that created a monopoly for the rating agencies.
Franken argues, “The Big Three rating agencies were paid a fortune by Wall Street to hand out pristine AAA ratings to the subprime mortgage-backed securities the banks issued — securities that turned out to be junk. No AAA rating? The issuer would take its business — and its hefty fees — elsewhere.” Franken believes there is a giant entity called “Wall Street” that operates out of a swank office in Lower Manhattan. He thinks there is a star chamber of elites who operate as a syndicate and cooperate to screw the rest of America. What’s more, he actually thinks there is an open market of ratings agencies to choose from. He’s gravely mistaken.
From Gretchen Morgenson’s excellent book, ‘Reckless Endangerment,’ she writes about the virtual monopoly extended to the big three ratings agencies by a SEC 1975 rule. “In the rule, the SEC required that brokerage firms base their capital requirements on investment ratings issued by nationally recognized statistical rating organizations. Three of these were dominant: Moody’s, Standard & Poor’s, and Fitch Ratings. Because of this rule, the companies enjoyed a duopoly – only two ratings were needed for a security to be sold to investors – and were protected from competitors by the substantial barrier to entry established by the NRSRO rule.” In other words, there was no ‘taking their business elsewhere’ due to SEC rules. The big three had a government sponsored market that couldn’t be broken.
Even Franken recognizes this ‘oligarchy’ established by the federal government. However, instead of opening up the market to competition, Franken argues this, “Our provision directs the Securities and Exchange Commission to create an independent self-regulatory organization that would assign the initial credit ratings of securities to one agency. The assignments could be based on agencies’ capacity, expertise, and, after time, their track record.” This is just more of the same that got us here. Instead of addressing the root causes of the problem, bad paper backed by government sponsored entities and rated by an oligarchy, Franken would just create another government body to dictate credit ratings. Instead of cleaning up Fannie Mae and Freddie Mac, opening up the market to more scrutiny, and allowing the marketplace to use their own due diligence to establish loan standards, Franken wants another government agency.
Franken presumes if we just create another watchdog, we will eliminate poor choices. This presumption is also fundamentally flawed. Who will watch the watchers? Congress did a poor job keeping an eye on their creations Fannie Mae and Freddie Mac and now we are trillions in the hole for backing them with our collective credit. Yet, the Dodd-Frank financial strangulation law does nothing to fix the perpetrator of this mess. The ratings agencies were certainly complicit in this gigantic fraudulent enterprise, but they were working with a series of political, and not economic, policies that forced bad loans into the system. They were empowered by a series of policy decisions that created a beast. Instead of opening up the market and allowing bad decisions to pay for excesses, we just create another agency which will be bullied by the likes of Rep. Maxine Waters and perverted by arbitrary rules and bailouts.
Franken’s little crusade right now isn’t intended to fix the financial mess we’ve got ourselves into. His piece is payback to the rating agencies for downgrading his Party and president. He rants, “The Big Three are well aware that their fates rest, in part, on the outcome of this SEC study, due out next year. And the S&P’s recent downgrade may well have been the industry’s shot across the bow, an attempt to intimidate SEC regulators. It appears that the rating agencies have essentially gone from being recipients of bribery to the perpetrators of extortion.” He wants to behead the messengers. When S&P downgraded the nation’s debt rating, Franken saw red. But, essentially the rating agency was right. His Party and president have spent us deeply into deficits and debt for are far as the eye can see into the future.
So, when Franken argues he wants ratings agencies to be more thorough and more conservative, he doesn’t mean it. He wants ratings agencies to make political decisions and support his political philosophy, not responsible guidelines. His little diatribe is meant to force the rating agencies to back off from conservative findings, which of course is how we got into this mess in the first place. Franken’s had his hand in spending our future into oblivion, and he will not take responsibility for his malfeasance. Instead he wants to use the power of the government to pervert the system and wallpaper over his extravagance.
Franken’s false presumptions are exactly the kind of things which has created the moral hazard that came crashing down on us in 2008. We cannot ‘force’ the market to do things without creating bubbles and perversions to the market. We cannot legislate our way out of financial difficulties. The market must be allowed to correct and adjust bad investments. We must allow entities and investors to fail as well as succeed. I’ll leave you with these words from Morgenson.
“In the end, analyzing the financial crisis, its origins and its framers, requires identifying powerful participants who would rather not be named. It requires identifying events that seemed meaningless when they occurred but had unintended consequences that have turned out to be integral to the outcome. It requires an unrelenting search for the facts, an ability to speak truth to power.”
What it doesn’t require is another power hungry, Washington agency who will regulate us into another economic crisis created by government meddling.
Crossposted at Looktruenorth.com