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A Great Article On The Fourth Catalyst Of The Financial Crisis

Posted by MIKKEL FISHMAN, Economics Editor in Economy.
Oct 19th, 2009 | Comments

In my mind, there are four primary catalysts behind the causes of our financial woes. The first is governmental monetary and tax policy that provides way too much liquidity and encourages ever rising asset values. The second are the major banks that took advantage of deregulation (particularly Glass-Steagall) to create monstrous speculative enterprises backed by government supported deposits (Yves Smith has a great post about a trader that made $100 million in bonuses and shows how his strategy could only work in such a place). The third catalyst — and one that is nearly universally ignored — is global trade policy that enabled the United States to run massive trade deficits and assume the policies we did. If China, Japan, the Middle East, et al. didn’t pursue mercantilist policies then trade flows would have naturally prevented a liquidity bubble (this problem is continuing and is a massive question mark going forward).

The fourth catalyst is merely the keystone of the operation. The debt ratings companies didn’t provide any of the foundations necessary for the bubble(s) but they were necessary for it to occur. They were the ones that helped obfuscate the dangers by providing solid ratings to absolute dreck, and had front row views to see the securities fall apart but did nothing. The reason why is simple: ratings companies get paid by the issuers and thus if they don’t give the ratings that are “asked” for then they will quickly find themselves losing business. Thus, the entire idea of the ratings company as a neutral observer is incorrect.

McClatchy’s has an excellent article that details the problems, and how the companies actively suppressed views that tried to stop the madness:

As the housing market collapsed in late 2007, Moody’s Investors Service, whose investment ratings were widely trusted, responded by purging analysts and executives who warned of trouble and promoting those who helped Wall Street plunge the country into its worst financial crisis since the Great Depression.

…

Instead, Moody’s promoted executives who headed its “structured finance” division, which assisted Wall Street in packaging loans into securities for sale to investors. It also stacked its compliance department with the people who awarded the highest ratings to pools of mortgages that soon were downgraded to junk. Such products have another name now: “toxic assets.”

…

To promote competition, in the 1970s ratings agencies were allowed to switch from having investors pay for ratings to having the issuers of debt pay for them. That led the ratings agencies to compete for business by currying favor with investment banks that would pay handsomely for the ratings they wanted.

Wall Street paid as much as $1 million for some ratings, and ratings agency profits soared. This new revenue stream swamped earnings from ordinary ratings.

…

Moody’s wasn’t alone in ignoring the mounting problems. It wasn’t even first among competitors. The financial industry newsletter Asset-Backed Alert found that Standard & Poor’s participated in 1,962 deals in 2006 involving pools of loans, while Moody’s did 1,697. In 2005, Standard & Poor’s did 1,754 deals to Moody’s 1,120. Fitch was well behind both.

And the kicker (emphasis mine)?

The ratings agencies were under no legal obligation since technically their job is only to give an opinion, protected as free speech, in the form of ratings.

“As an analyst, I wouldn’t have known there was a compliance function. There was an attitude of carelessness, or careless ignorance of the law. I think it is a result of the mentality that what we do is just an opinion, and so the law doesn’t apply to us,” Kolchinsky said.

Experts such as Columbia University’s Coffee think that Congress must impose some legal liability on credit rating agencies. Otherwise, they’ll remain “just one more conflicted gatekeeper,” and the process of pooling loans — essential to the flow of credit — will remain paralyzed and economic recovery restrained.

There is much more in the article. Please go read the rest as McClatchy’s is just about the best investigative newspaper remaining and needs the hits.

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TheMagicalSkyFather

See capitalism is a great idea but then you get a couple of actual capitalists and well......

CStanley

To promote competition, in the 1970s ratings agencies were allowed to switch from having investors pay for ratings to having the issuers of debt pay for them. That led the ratings agencies to compete for business by currying favor with investment banks that would pay handsomely for the ratings they wanted.

This part is baffling. Why was it necessary to 'promote competition' and how does that change even effect that outcome? Why shouldn't there have been competition among the investors who were paying for accurate analyses, instead of setting up and promoting the perverse incentive of having the sellers pay someone to rate their product. You wouldn't buy a house based on the home inspection paid for by the seller, and this makes no more sense than that does (less so, given the amount of money and risk involved in those transactions.)

mikkel

Well "competition" and "efficiency" are buzzwords to justify all financial "innovation," so if you ask that about any change that's what you'll get. Yves Smith likes to often point to Volcker's response to a question about what beneficial to customer innovations he's seen in the last 30 years and all he could come up with is the ATM...he said the rest was just to give large players a leg up on everyone else.

The article also left out another part that has still not been resolved. Several state AGs (e.g. connecticut's) sued the ratings agencies claiming that they give government bonds lower ratings than equivalent corporate ones.

The reason they are suspected to have done this is so the government bonds would be forced to buy insurance from the monoline insurers, raising the cost of the bond and indirectly defrauding the tax payers. Of course as you can see by the date, larger events overshadowed that allegation.

CStanley

Or, socialism is a great idea until you add a couple of actual socialists.

That's actually the problem with any system, MSF...on paper it looks great but when you add human beings the actual outcome isn't what is predicted or advertised. The reason that many of us still see capitalism as the 'worst system, except for all the others' though is that for the most part it works with the baser instincts of people instead of assuming that everyone will cooperate benignly for the greater good. Quite often (see my other comment for how that applies to this particular case, for instance) it's when things are done to tinker with the market forces that the greed of some individuals then goes unchecked. There also, of course, are instances when a particular sector or industry is immune from market forces or for various reasons there needs to be some regulation or intervention as well, so I'm not by any means advocating a completely laissez faire economy.

Zzzzz

I agree, however, their are lots of such schemes that make absolutely no sense. The partial privatization of the California energy market was an absolute disaster. Outsourcing military support contracts have led to, not improved support for the troops, but worse food and so forth at much greater cost. Medicare Advantage is an utter boondoogle. You get these kind of results when people craft policy based on ideology (and who their campaign donors are) instead of common sense. All of this is not to say that left wing ideology hasn't led to many failed experiments, too.

CStanley

Well "competition" and "efficiency" are buzzwords to justify all financial "innovation," so if you ask that about any change that's what you'll get.

Yeah, basically I was thinking it sounds like the kind of rationalization you get when the regulators decide to collude with the private market interest, and mostly no one pays attention or stops to think about how the rationale doesn't really make any sense and could easily lead to an undesired outcome.

CStanley

Yep, I pretty much agree and those examples would likely fall under the category I described, of instances where market forces won't work well. Energy/utilities tend to not work because of the extensive infrastructure needs, and military support almost always ends up being on a no bid contract basis because so few companies can handle the environment/logistics. When those things get opened up to privatization, you certainly don't get a bunch of competition from startup companies, and without competition, there's no real market force keeping things under control.

mikkel

You may be interested in this.

What is emerging is that the people on the ground in nearly every institution (both government and private) saw what was going on, realized it was wrong, tried to warn their superiors and were marginalized or fired.

CStanley

It is incredible, except that it almost seems that that had to be the case. Anyone with a shred of common sense had to have known that what goes up has to eventually come down, and bubbles eventually burst- and if you were working in that environment it's hard to imagine how anyone didn't see some of the policies and events without realizing that the growth wasn't real or sustainable.

Anyway, to me this is why the whole left/right political debate about more regulation or less regulation (or even what we were just discussing here, public sector oversight vs private market forces) is mostly moot. Both approaches can, and do, fail...especially when the public isn't paying much attention. You can have all the regulation that an ardent leftie would dream of, but if it's not enforced then it's completely meaningless. And what a lot of mainstream Dem voters seem to fail to notice is the frequency that their own party might give lip service to 'regulation' while actually making it toothless because they too are benefiting from the collusion.

mikkel

Mainstream perhaps, but a lot of the maligned progressives are on top of that and becoming increasingly louder. The issue will be if they decide that things can be different if the people at top are different or whether it is impossible to get rid of and a different tack should be taken.

I do feel that your point about the public engagement being primary is right on. All countries have issues (primarily due to demographics) but a lot of socialist countries where the citizenry feels very engaged and informed -- and is willing to quickly turn on groups (both public and private) that misbehave -- have more of a social safety net while having equivalent (or often times lower) effective tax rates and equivalent real economy business friendliness. Of course all those countries are small, averaging around 10 million people, so I wouldn't pretend that they are universally applicable, and the larger socialist countries do have major structural problems similar to us.

It seems to me that there is the possibility of a neofederalist movement where both progressives and conservatives prefer local power structures because they are more responsive. A lot of times I wonder if the Liberal answer of large government is merely an historical accident that arose because of civil and labor rights issues, both of which have been nearly completely addressed.

TheMagicalSkyFather

I am not saying one system is better than another, my preference is for a more hybrid model like pre-1980 but with regs that actually nip this crap in the bud instead of enriching the politically well connected. The market will not take care of itself nor will it function efficiently if tampered with too much but of course when it fails it will be inevitably tampered with so the only effective fix I see is strong and modern regs but I did have to point out the obvious fail on the part of the free marketers. It sounds like a good idea but it is just another ideology that fails due to its ideologues that adore it for its potential for abuse. Oddly if you want as little gov interference as possible it would be a good time to push strict regs that would actually help the people corps and nation since the problem with our current market is its boom and bust cycles that destabilize the economy and the nation which means whenever it busts we will tamper further with it. Sure we will usually tamper with it in the interests of a few but tamper we will until the market stabilizes since we have to eat and pay our mortgages and ideology does not feed children.

TheMagicalSkyFather

This is actually why I liked Ron Paul so much. If CA wants to be socialist, ok. If GA wants zero regulations and taxes for corps, ok(with the exception of things that can damage other states properties). This could be a very beneficial thing for the country since if you did not like your gov, move. CA of course would not have near the financial issues if they kept more of the money that they send to the FED in taxes that then get shifted to GA to build roads.

mikkel

While I agree about economic issues, I am not in agreement when it comes to civil rights/privacy issues (some of which Ron Paul would get the government out of) because I feel it is unjust to force someone to move based on things like that.

Also while I have no problem with Ron Paul's vision in general, I don't see a way to get there without causing collapse due to institutional changes. Look at something as simple as the homeowner's mortgage tax deduction for example. We can't even get rid of that (despite near universal agreement that it's bad) because it would automatically lower home values by 10-15% and wipe out hundreds of billions in equity. I don't see anyway we could abolish the Fed and downsize the government like he's calling for without massive economic problems -- literally 50%+ of leverage would dry up and lead to mass depression.

Of course that is the argument against inflationist policy in general and I am also sympathetic to the notion that it forces us to have rampant consumerism and environment overuse...it's a very intractable problem.

TheMagicalSkyFather

And the argument you made above is why I moved to Obama since he was the Statist I trusted the most. I also agree on social issues though I am sure that certain things could be dealt with via inter-state commerce. Meaning you can make abortion illegal in this state but you cant make laws about it being used in other states even by your own citizens. Do not get me wrong it would create certain states I would love and others that I would refuse to even fly over but I think that is the best option for any type of real socialism or libertarianism in this country.

The economic fall out though will mean this will only likely be tried if the FED goes bankrupt or something equally economically catastrophic.

yetanothermoderatevoice

"The third catalyst — and one that is nearly universally ignored — is global trade policy that enabled the United States to run massive trade deficits and assume the policies we did."

I'm pretty sure all sorts of economists talked about that for years, Martin Wolf wrote a book about it, Menzie Chinn wrote some high profile articles about circa 2006, Brad Setser seemed to talk of nothing else etc. Brad deLong even said that it was the crisis that everybody expected, rather than the one we actually got.

No?

JeffersonDavis

"Outsourcing military have led to, not improved support for the troops, but worse food and so forth at much greater cost"

I have to partially disagree with you. Yes the greater cost was there with KBR doing the support, up to 27 dollars per meal served in Iraq and Afghanistan....However, the food was MUCH better than prior to that time. We went from MREs and SOS to very good food. Other than that, you're right on.

mikkel

I meant universally ignored as a catalyst of the crisis that did happen. While a lot of economists have talked about it as a separate issue, they've done a very poor job of tying it into the rise of the asset bubble. Brad Setser had really interesting data on how the flows were affected because of the crisis, but never quite pinned down that the reason that they so violently turned was because they were a driver of it as well.

I admit I am biased to trade flow explanations of international crises, for the simple fact that in my (admittedly shallow) perception, it seems like 90% of major economic crises were caused by severe trade imbalances. That said, Michael Pettis has been on this explanation from the day I first read him, and has been stunningly correct about its implications and what the actors would do in reaction. I do remember Martin Wolf writing a similar thing at the beginning of the year as well.

Other than that though, in general people have responded closer to deLong.

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