Inside Financial Services

Plenty of Blame to Go Around.

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In response to those of you who chided me last week in the comments section here after I laid into the Justice Department for suing Standard & Poor’s over its triple-A ratings of subprime CDOs, let me be clear: no individual on the face of the earth loathes the rating agencies, or believes they contributed mightily to the credit crunch, more than yours truly. The agencies got the ball rolling with their stupidly optimistic ratings in the first place, then helped fuel the panic later on with their jumpy downgrades of banks and other key players. As the crisis played itself out, the agencies never failed to make things worse. If they didn’t exist, the world would be a better place.

So I’m not a fan, OK? But while it’s one thing for the rating agencies to be publicly called out for their idiotic actions before and during the crisis, it’s another thing entirely for the federal government to target them and only them-among all the bad actors who contributed to the crunch-with accusations of negligence and potentially ruinous lawsuits. The fact is there’s a lot of blame to go around: the housing bubble and credit crunch came about from the often-conflicting motives and interactions of many players. It was so big and complex that no single entity could have engineered it alone. The feds’ singling out of the agencies for particular torment is extremely unfair.

Yes, the agencies deserve some blame for what happened. But they sure weren’t the only ones who messed up. Rather here’s my take on what happened, who messed up, and why.

The main storyline in the media is of course that the main bad guys were the big banks. Certainly the banks did their bit to add to the chaos. They were the ones who cooked up the doomed securities and sold them to investors in the first place. Yet some banks (Wells Fargo, JPMorgan, and U.S. Bank, for instance) had the foresight and controls to see that things were getting out of hand, and pulled bank. One wonders why they all didn’t. They didn’t because too many banks were poorly managed, or greedy, or both.

So the banks played their part. Then again, the buyers of the securities were run by well-educated, rational adults who presumably (hopefully!) were supposed to know what they were doing. Consenting adults, let’s call them. These are big-time money managers, remember, who run billions. They surely deserve their share of the blame for letting things get out of hand. And don’t say that the buyers were relying on those agency ratings. Shame on them if that was the extent of their due diligence.

For that matter, the banks’ big subprime push came about in direct response to the federal government’s housing policy, which encouraged (and still encourages) bank lending to low-income and other “underserved” groups. That’s why we have the Community Reinvestment Act, for example. And, more to the point, it’s why the GSEs steadily loosened their standards for subprime loans earlier in the decade. Those new GSE guarantees made erstwhile risky subprime loans into much more attractive propositions for lenders. The government wanted banks to do more subprime. In building up their subprime-lending operations, the big banks were simply responding to the government’s policy.

At this point, some of the conservatives in the audience will raise their hands and try to blame the government for the whole mess, the same way that the media has tried to blame the big banks. No. I don’t recall Lehman Brothers, Merrill Lynch, Goldman and the rest being dragged kicking and screaming into the subprime lending marketplace as a result of the government’s policies. What I do recall was the big banks eagerly spending billions to integrate their origination and distribution operations so they could ramp up volumes. Would those volumes have ballooned the way they did without the government’s urging? No way! But the banks were by no means reluctant players.

Then there were the fraudulent borrowers. I know we’re all supposed to think of defaulted subprime borrowers as pathetic losers who got hornswoggled by evil banks into borrowing more money than they should have, but the reality is somewhat more, er, complex. As the bubble inflated, more and more borrowers took liberties with the truth on their loan applications in order to get in on the action. They lied about their incomes. They lied about their assets. They lied about their employment status. They lied about their primary residences. By the end of 2008, close to 5% of subprime mortgage loans were first-payment defaults. Which is to say, the borrowers weren’t living in the properties but had bought them as speculations (regardless of what they said on their loan applications) and were walking away when they saw the property was declining in value. In these cases, the borrower had taken advantage of the lender, not the other way around. The volume of fraud was not small, and contributed meaningfully to the size of the bubble and resulting crash.

And don’t forget the bond insurers. They’re supposed to be the dispassionate propeller-heads who-unlike the rating agencies-actually had skin in the game. What in the world were they thinking?

Which gets me at last to the rating agencies. One could make the argument that if there’s one single set of players who were responsible for the mess, it was the agencies. No triple-A ratings, after all, no subprime CDO buyers. And it’s easy to portray the agencies as avaricious fee-grabbers willing to do whatever issuers wanted. But the reality wasn’t so simple. Recall that early in the cycle there was a certain logic to the agencies’ models for assessing the creditworthiness of subprime CDOs. Back then, the thinking was that there was no single, national housing market, but rather many local housing markets that were independent of one another (uncorrelated!) and driven by different macro factors. So if an investor in subprime mortgage securities could diversify among those many markets, he could earn subprime-level yields at reduced credit risk, thanks to diversification. That was the whole rationale for subprime CDOs, and it made perfect sense at the time. What the models did not anticipate, however, was the emergence of a nationwide housing bubble that was in turn caused by a combination of misguided government policy, myopic bank management, fraud, sleepyheaded fixed-income portfolio managers, and naÏve bond insurers. (Also, some CDOs turned out not to be as diversified as people thought.) The models blew up, and so did the CDOs. Why the rating agencies failed to realize that their models would be useless in the bubble environment that they must have known was happening is beyond me. But they didn’t. This is not the first time, I hasten to add, that the people at the agencies have shown themselves to be non-geniuses.

So it wasn’t just the banks’ fault, or the agencies’, or the government’s. Many key players involved in the process messed up in a very big way. The government’s singling out of the agencies for punishment is a disgrace.

What do you think? Let me know!

19 Responses to “Plenty of Blame to Go Around.”

  1. Alan F

    In my opinion, the biggest failure of the Obama administration has been to take some sort of action to put an end to everyone attempting to get back their losses. Everyone was to blame, some got caught holding more of the bag than others. The long drawn out battle among all the parties involved trying to recoup losses has been the biggest obstacle to getting housing and the economy expanding as fast as it should be. Continuing the drawn out blame process with lawsuits is the exact opposite of what needs to be done. Idiots.

  2. oy

    So if everyone is to blame, no one is to blame. Alternatively, go after all of them, but that’s not practically feasible. So go after those you think you can nail, say, some big rating agency that leaves a paper trail with lots of incriminating evidence.

  3. rivvir

    Not much to disagree with, though, or course, there is some. 1-Haven’t the banks paid up some for their part? If so, then how can you say the rating agencies are being singled out? Regards the gvt, a) i may be correct, i may be incorrect, but i seem to recall a head or two rolling; b) did gvt regs call for lending to liars? Pick on the regs all you want but unless they pushed lending to liars, you don’t have much of a case. The liars, you call them fraudulent borrowers while i call them liars, same garbage, had the mortgage wheeler-dealers complicit with them. I guess maybe the only way to deal with that is for the gvt to hire an army of auditors and at least spot check 1 in 5 or 1 in 10 of every app that comes down the pike. Unfortunately, many of those qualified to do the job were in the reserve and over in iraq/afghanistan. Just kidding, about a serious situation i realize, but if you can go overboard i can as well. Anyway, did gvt push for liars to get loans? And then there were us, probably the biggest enemy to sane investing as you can find. You know you and i were certainly our own greatest enemies to our own respective portfolios. We probably got what we deserved. We deserve at least a good portion of the blame for our own respective investment losses.

  4. Richard Barrett

    As a very happy investor in one of your funds, I agree with everything that you said. I think the one point that many observes forget is that the underlying fallacy was a belief that the value of housing would never materially decline for any extended period. I started out a career in banking as a Federal Reserve bank examiner. The first principle that you learned was that a loan should be based on cash flow and not liquidation of the asset. Liquidation was a last resort that generally ended up in some loss of principle. Also, it amazes me that the banking agencies accepted such absurd lending practices, such as no verification loans. The banking agencies always had the power to prevent such excesses and were negligent like many other players.

  5. Don - retired CFO


    Don’t forget the Federal Reserve that kept rates artificially low for too long after 9/11. Investors started looking for higher yields, hence the rush to MBS’s and CDO’s which had the high ratings.

    Keep up the good work.

  6. Don Gher

    Tommy, like Agatha Christie’s “Murder on the Orient Express,” there were multiple hands on the murder weapon!

  7. elaine sandler

    Mr. Brown, As a lay person I was impressed with your articulate assessment of the subprime mortgage debacle which disrupted many lives, mine among them. I certainly agree with your blame-to-go-around conclusion. There can be no doubt of that. My question to you – why should rating agencies even exist if they are unreliable and compromised in the greed scenario. Their inability to watch out for the average investor by issuing appropirate warnings and low ratings, might have alerted many of us to the dangers that would invariably entrap. This was an insidious bubble that destroyed retirement plans for many and rendered real estate unaffordable for individuals who lived in places like Phoenix or Las Vegas, among others. Even here in Aspen, where I live, real estate took a 20 to 30% haircut – an unprecedented occurrance. Personally, if I were to pick a party to castigate it would be the government followed by the rating agencies. The rest was greed and poor leadership. Amazing to me that the CEOs of banks that failed, unacceptably walked away with plenty.
    Rating agencies should warn danger. They failed to do it, and since then, I barely glance at a rating . They have lost credibility and standing. As far as I am concerned, they can go away. I understand too, they are paid by the companies they rate? How does that make sense???
    I’d appreciate a response and thanks.

  8. PSG

    Tom, You hit the nail on the head — “…What the models did not anticipate, however, was the emergence of a nationwide housing bubble….” and that brings us back to the stock picking analogy — the longer, steeper, bigger the market (housing in this instance) appretiation, the more the agencies should be anticipating a burst. Why do the (stock market) short sellers come out of the woodwork as markets appreciate? And if rating agencies’ Ivy League PhD’s were fixated on “models” without stepping back for the big picture, shame on them.

    All the other sharers-of-blame mentioned above are relying on (AKA: pointing their fingers at) the Rating Agencies’ “AAA” certification. Yes, those other groups (with the exception of bond insurers) were guilty of taking advangtage of the situation, but only the Agencies represented themselves as having a valid opinion of risk — and that’s where a judge can hang his hat. Bond insurers shot themselves (in addition to bondholders) in the foot.

  9. Nick Ruffin

    Tom, All true, but you left out one important participant: Alan Greenspan and his hands off , let the markets discipline themselves Federal Reserve.

  10. big papa

    excellent points–They never go after any Co. that has a union—Justice will hopefully lose this one and waste our money win or lose

  11. swm

    Picking on ! You mean finally getting around to. Turning a blind eye or simply going along to get along is criminal. Not doing anything is tacit approval of what they did and encouraging them to do it again. I thought this day would never come.

  12. Former regulator/banker/consultant

    Tom, once again you are spot on!
    Two key culprits that you failed to mentioned are the banking
    Regulators that failed to identify this unsafe and unsound lending
    along with the excessive concentrations that it created, and the real estate
    brokers/agents that were inducing borrowers to purchase
    properties they could I’ll afford on the premise that their value
    would continue to increase at phenomenal rates. In so doing, they
    were qualifying buyers that had no means to repay in the
    event of a market downturn that few anticipated.

  13. Bama Banker

    While I understand your point, the fact is that many of the other players in this debacle have suffered significant financial, career and/or life-impacting consequences as a result of their poor judgment and bad behavior, but the ratings agencies have barely paid a price to date for their serious failure to accurately assess and classify the risks in the CDO’s. The issue is accountability – and therefore I support the government’s effort to hold them responsible and create a moral hazard that might improve their actions in similar future situations.

  14. cgarval

    What about the financial press, the appraisers, the local mortgage brokers and real estate agents? What about all the graduate students flocking to Wall Street to make as much money as possible? The reality is that we were all involved in the mess.

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