I have issued a bunch of posts, each titled the “the cause of the crisis”, and each giving a different cause – but each of these causes was itself caused by, or caused, all of the other causes.
This post addresses ratings for debt.
Much analysis of the crisis has been in terms of banks gaming the system. But if banks were gaming the system, they were gaming it by ratings inflation – and regulators are wholly responsible for ratings.
In the days before banking became a branch of the state, U.S. banks voluntarily maintained capital-asset ratios in the range of 10 to 20 percent, so that a rainy day when lots of customers wanted to withdraw at the same time would not trigger a crisis
With FDIC insurance protecting all deposits, customers don’t worry about bank safety – in fact it is illegal to leak safety information about banks. So banks have little choice but to steer as close to the wind as the regulators will allow – maintain the lowest capital ratio, and invest in the riskiest securities. Any bank that follows a different policy will lose market share.
So what did the regulators require? Under Basel, they required less than half the capital for AAA securities as they required for individual mortgages, resulting a massive world wide demand by banks for AAA rated securities, a demand entirely created by regulators, a demand for securities that were rated as secure, rather than a demand for securities that actually were secure.
So all the financiers proceeded to game the system by rating inflation, and this gaming is what people are referring to when they argue that there was “deregulation” – the problem being not that regulations were relaxed or removed, but that stern and strict regulations created the incentive to weasel around them, rendering them ineffectual and counterproductive.
So it did not matter to banks whether ratings were true, merely that the ratings agency had been blessed by the regulators. In 1975, the SEC made had made rating into a branch of the government by mandating that companies obtain a rating from Moody’s, S&P, or Fitch. Since then the power and wealth of the rating agencies comes entirely from government favor, not from anyone believing that their ratings have anything to do with reality. Thus any connections between ratings and reality, or lack thereof, depends entirely on the regulators, and has since 1975.
The regulators had little incentive to demand connection to reality, and considerable incentive to the contrary. The biggest beneficiaries of flagrantly fraudulent ratings were Fannie and Freddie – quasi governmental organizations whose nominally private management is directly appointed and supervised by congress. Genuinely private beneficiaries of fraudulent ratings, notably Washington Mutual, took extraordinary measures to please the regulators, by hurling vast amounts of mortgage money at targeted voting blocks, thereby making their securities even more worthless, but ensuring that ratings would not reflect this fact.
In 2005 November, large numbers of people in the business, AIG among them, realized that these mortgage securities were extremely insecure, and in a great many cases, not worth very much. So from late 2005 to mid 2007, we had a massive, well known, and extremely serious disconnect between ratings and reality.
This was the “irrational” behavior of the markets during that period. Markets were “irrationally” behaving as if official security ratings were total lies.
The regulators could have asked the ratings agencies to issue more credible ratings. They failed to do so, indicating that the regulators approved the fraudulent ratings, and perhaps insisted on them, that this was not “deregulation”, was not the regulated weaseling around the regulations, but regulation, the regulators trying to get the market to swallow worthless mortgage backed securities.
Before 2005 November it might well have been, and probably was, the free market evasively weaseling around regulations by inflating ratings with a nod and a wink, but between 2005 November and mid 2007 it was regulators trying to force feed worthless affirmative action mortgages down the throats of a marketplace that very plainly did not want them.
This is what links this cause of the crisis to causes that are each just as much the cause – off budget government deficits and affirmative action. The politicians and regulators wanted handouts to voter blocks, it wanted such handouts off the budget, and to conceal the expenditure from the voters and from themselves, wanted mortgage securities based on loans to deadbeats of politically correct racial voting blocks to be rated as secure.
Government regulation directly caused banks to buy AAA rated securities, and the government regulators are wholly responsible for what gets AAA rated. The only question is to what extent fraudulent AAA ratings were due to improper influence by the regulated over the regulators, with the regulators allowing the regulated to get away with evading the intent of regulations, and to what extent due to politicians trying to buy votes with off budget money. Before 2005 November, had to tell which of these mattered more. From 2005 November to mid 2007, it was @#$%^& obvious which of these mattered more. That security ratings failed to reflect reality after 2005 November shows that regulators and their political masters did not want them to reflect reality.