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.
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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.”
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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.
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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.