The Enlightened Despot

Mark Calabria of CATO has a good post up about the SEC’s limp suggestions for improving the credit ratings system. As I’ve worried here before, no one is suggesting an end to the oligopoly of credit ratings agencies, or moves to attach less official weight to the ratings they produce:

The thrust of the SEC’s current approach is more disclosure, such as releasing “pre-ratings” that debt issuers may get before final issuance.  Additional disclosure of ratings methodology and assumptions is likely to be useless.  Almost all that information was available during the building housing bubble.  The problem is that the rating agencies had little incentive to go beyond the consensus forecasts of increasing to at most modest declines in home prices.  These same assumptions were the foundation of almost all government economic forecasting as well, yet few believe that forcing CBO or OMB to disclosure more of their forecasts will cure our budget imbalances.  What is needed is a change in incentives.

Here again the SEC seems to misunderstand the incentives at work, but then recognizing such would force the SEC to admit its own role in creating those some perverse incentives.  The SEC’s notion that agencies issue favorable ratings in order to gain business misses the most basic fact of the ratings business - they don’t have to compete for business, any debt issuer wanting to place “investment grade” debt has to use the agencies, and often has to use more than one of them.  Due to a variety of SEC and bank regulations, there is almost no competition among the rating agencies.

The structure of this system pretty much guaruntees that CRAs will do a shabby job. The past few decades have proven that that is in fact what happens in practice. They are one of the most clear-cut bad actors in our recent crisis. But beacuse they didn’t directly cost anyone any money, and because any description of what is wrong with them is bound to be fairly dry and technical, there is no populist outrage directed toward them. So the system will remain in place. Sooner or later, they will agree to put a AAA rating on some new class of not-so-surefire debt. People who can convince their investors and regulators that this is meaningful will have a strong financial incentive to convince themselves as well. And we’ll all be worse off for it.

This has been a very video-heavy few days, but I can’t resist posting this. I promise there will be real posts with words in them again soon:

Some catch-up to attend to after two missed installments, so, without further ado, the links:

• Terrorists were arrested for attempting to blow up a synagogue a few blocks away from my childhood home. I assume the punishment is especially severe for that sort of thing. Unfortunately for them, they were using fake bombs sold to them by the FBI. The men had been under investigation for almost a year.
• The NYT reported the other day that ammunition sent to the Afghan government by the US and its allies had been discovered in Taliban hands. No one was under any illusions about the existence of ties between the Taliban and elements within the government so, in a sense, this isn’t news at all. It would be surprising if some of our ammo weren’t being used against us. But this sort of concrete discovery can sometimes focus thinking on an issue we already knew about.
• California is facing bankruptcy, and not just the moral kind. Voters rejected five out of six ballot measures introduced to address the fiscal crisis in a special election on Tuesday. The good news is that there has been a surge in public support for overhauling California’s constitution. Just about everyone who has even briefly thought about it agrees that the requirement for a supermajority on all matters budgetary is a complete disaster.
• CATO’s Jerry Taylor is apparently still not afraid to get jerrytaylored.
• The boy who hacked Sarah Palin’s email during the campaign has asked that the case against him be thrown out on the grounds that her emails were public records.
• Peter Kirsanow thinks that despite Dick Cheney’s unpopularity, Americans would want him in charge of any effort to defend the earth from destruction via asteroid. That is, to the extent that Peter Kirsanow thinks.
• Felix Salmon says there is nothing to worry about in the possibility of a downgrading of US debt, because the ratings agencies are now irrelevant. I hope he’s right, and there have certainly been some positive signs, but I think some more concrete steps need to be taken to make the ratings system in its present form as irrelevant as it deserves to be.

The quote of the day is this beautiful piece of understatement from Ben Smith:

The Palin family media strategy can be hard to figure.

You don’t say. He’s reacting in particular to the magazine cover above, which, in case you missed it, includes this equally quotable gem from Bristol Palin:

If girls realized the consequences of sex, nobody would be having sex. Trust me. Nobody.

Ah, Bristol. Ah, humanity.

Finally, apropos of nothing in particular, here’s Nino Brown’s defense of his murderous - though fictional - reign as a crack kingpin:

I’m fairly certain I’ve seen someone else point out how misleading the term ‘toxic assets’ is, but I don’t remember who, and in any case, it’s still everywhere, so it clearly needs saying more often. That it is effectively deceptive is demonstrated by the sentences it appears in so often, things like: “Bank X won’t be solvent until it gets some of those toxic assets off its books.” Nonsense! If the banks just needed to get toxic assets off their books, they could give them to me. I’d be delighted, but the banks would never do this, because toxic assets are assets and assets are a good thing. Having lots and lots of bad loans is terrific - they will generate at least some revenue. The descriptors ‘bad’ and ‘toxic’ here refer to the fact that these assets are producing - or are expected to produce - less revenue than they were - or were expected to - before. The assets are still nice, but if you borrowed money at a rate that is only sustainable based on your old valuation of them, you are in trouble. But that doesn’t change the fact that it’s the borrowing that is your problem. Assets are never bad - it’s the liabilities that aren’t so fun.

This might seem like nitpicking, but it’s odd that when people are dealing in equity rather than debt, they don’t get to obscure the problem verbally in the same way. The ‘toxic asset’ business makes it sound as if the problem is totally out of the banks’ control - their assets just up and turned on them. The situation is very different when a stock portfolio goes bad. You might feel like a jackass for putting all of your money in E-Graters.com, but you don’t get to pretend that your problem is having too many toxic stocks. Your problem is that you have bills to pay, and you can no longer cover them by selling a few shares of E-Graters.

All of which is to say that there is not necessarily a problem with heaping loans together and then slicing up and securitizing them. There is a problem with assigning an absurdly high value to the resulting securities, and balancing your books accordingly. And there is a very big problem with a system that attaches great importance to the judgment of a small number of highly interested parties (CRAs) who help everyone else get away with making these overvaluations.

From Zero Hedge:

(click for a larger, legible version)
King Felix comments:

In a nutshell, the problem is the classic one: on the left-hand side nothing is right, and on the right-hand side nothing is left, at least absent government intervention. Says Tyler:

As the government has the best information about the true sad state of affairs, it is likely that as more and more information about the weakness of the financial system comes to light, more of these support guarantees will become utilized to their full extent. This also means that the asset side of the balance sheet is potentially “inflated” by almost 75% and the net result could be the most dramatic collapse in a banking system’s assets in recorded history as over $8 trillion in “assets” are reevaluated.

This doesn’t need to be probable to be terrifying: it just needs to be possible. And Tyler’s point is that the government has put all of these programs in place precisely because it’s possible. So: fear is entirely rational here.

As FDR cautioned (according to the Onion): We have nothing to fear but a crippling, decade-long depression.

Matt Yglesias: thoughtful, intelligent, open minded, and yet - time after time - dead wrong. Here he goes again:

Here’s one idea:

Of course there are many illegal markets that would generate stimulus were they to be legalized. Here are some of the big ones.

1. Drugs
2. Guns
3. Prostitution (except in Nevada)
4. Gay prostitution (even in Nevada)
5. Gambling
6. Trade with Cuba
7. Liberalized immigration

I’ve heard a lot of that kid of thing lately, but though I’d be a supporter of several of the items suggested on the list, I’m a bit skeptical of the theory. These all sounds to me like things that would do more to raise the potential output of the economy than to raise the actual output of an economy that’s producing far less than capacity right now.

…

With regard to things like drugs and prostitution, bringing some transactions that are already happening into the above-ground economy would certainly boost our GDP measurements. But these are transactions that are already happening. Shifting them from the illicit to the licit economy doesn’t actually change the fact that there are already people in America earning a living as prostitutes or pimps or drug dealers.

With so much incorrectness, it’s hard to know where to begin. Yes, it’s true that increasing measured GDP isn’t the same thing as getting richer, but making formerly black market activity legal isn’t just an accounting trick - you would actually be altering what happens in that economy substantively. For one thing, these activities would now be taxed. Of course, raising taxes isn’t generally stimulative, but presumably the tax burden would be more than offset by the lower cost of doing business without interference from law enforcement. More importantly, pimps and drug dealers would be able to deposit all of their income in banks. When drug dealers have, say, $26 million in cash lying around their houses, we are cheating ourselves out of vast sums of potential investment capital. And the rumor on the street is that the banks could use a little extra capital these days.

Yesterday, pundits and bloggers got to play one of their favorite games: Stock Exchange-Pathetic Fallacy Madlibs. The rules are very simple: start by assuming the stock market is a living, opinionated being that reads the newspapers, pick a recent movement in stock prices and a fun, more-or-less coeval news item, then write a few sentences explaining how the market chose to do the former because of its feelings about the latter. So a few weeks back we had ongoing debates about whether the Dow was terrified of our first socialist president or sulking in its room because Republicans weren’t playing fair.

To be fair, what went on yesterday wasn’t quite as silly as this. For the most part, analysis of this sort shows every sign of just being made up after the fact. The markets do something dramatic, and a fable explaining why is created out of the news of the day. This sort of analysis is generally worthless, as I’ve written before. There are, however, some events which everyone expect will have a noticeable, very short-term effect on markets ahead of time. The most common examples are Fed meetings - everyone waits with bated breath to here what the new interest rate targets will be, and, whatever decision comes down, traders go nuts. In these cases, it at least makes sense (usually) to say that there is a causal connection between the news and the market activity; the release of details about Geithner’s plan was certainly such an event.

But the fact that we can reasonably assume stocks have risen at least in part as a reaction to the Geithner plan, it doesn’t at all follow that that market activity tells us anything interesting about the plan or whether it will work. For starters, investors don’t become more bullish about stocks when they get good news, they become more bullish about stocks when they get news that is good for the companies in question. If Congress were to pass legislation promising trillions of dollars to banks to round up and drown puppies, bank stocks would no doubt soar. But this wouldn’t be evidence that the market thought the puppy-drowning scheme was brilliant; it would be evidence that the market responds predictably to the transfer of trillions of dollars.

Secondly, consider this, from King Felix:

I had a brief discussion with Jesse Eisinger yesterday about the stock market reaction to the Geithner plan. The central question: do you look at the level of the index, or do you look at the amount that it moved over the course of the day? Geithner’s first attempt at introducing the plan resulted in the Dow falling 382 points to 7,889; Geithner’s second attempt saw a 497-point rise to 7,776.

If you ignore the direction and just focus on the Dow as a snapshot of how the market feels about the prospects for the economy, you could make a case for investors being more optimistic the first time round than than they were yesterday. That’s true even if you look at a sensible index like the S&P 500, which closed yesterday at 823, down a smidgen from its February 10 close of 827, rather than looking at the silly but ubiquitous Dow average.

Ultimately, Felix is simply trying to make the point that “it’s ill-advised to use day-to-day movements in the stock market as much of a barometer of anything.” But in his example, looking at the price rather than the short-term performance makes things even worse. As discussed above, the entire exercise is nothing but hand waving unless we are looking at extremely short-term movements in the immediate aftermath of a major announcement where we can confidently assert a straightforward causal connection; once you start looking at even slightly longer-term (and more meaningful!) trends, you can’t really talk about the market reaction to, in this case, Geithner’s plan, because there are too many other factors affecting stock movements.

Ultimately, though, what really makes these market jumps useless as a means of evaluating Geithner’s plan - or anything else - is that we actually shouldn’t expect the stock of, say, Citi to go up if investors think the plan will help Citi and down if they think it will hurt the bank. Rather, we should expect Citi stock to go up if the plan that is announced is more helpful to Citi than they expected it would be. Investors knew that a plan would be announced - just as they know when the Fed is going to make an announcement about target rates. So their expectations should already be priced in to the relevant stocks before the announcement is made. Good news should lead to a drop in prices if investors expect great news. Bad news should lead to short-term gains if investors expect terrible news. So unless we’re very sure that the market was optimistic about Geithner’s plan before the details were announced, we really can’t know what to make of what happened immediately after.

For the most part, the reflexively anti-stimulus crowd on the right have been dead wrong about our response to the crumbling economy. But there are, of course, degrees of wrong, and it irritates me to no end to hear their views repeatedly bashed as ‘neo-Hooverism’. The latest instance comes from our friend Matt ‘the YZA’ Yglesias. First, he cites Kevin Drum, coming correct:

Consider, after all, that our response to the Depression appears to have been 180 degrees wrong. We literally did almost everything possible to make it worse: we tightened the money supply, balanced the budget, raised interest rates, passed protectionist legislation, and allowed banks to fail by the hundreds. It escalated a panic into a Depression. And this time around? Just the opposite: interest rates are close to zero, we’re running an enormous budget deficit, protectionism has largely been kept at bay, money is being pumped into the economy prodigiously, and with the notable exception of Lehman Brothers banks are being saved right and left. These actions have reduced a panic to a severe recession. If we had taken the same policy actions that Hoover and Mellon took in the 30s, does anyone doubt that the results would have been another Great Depression? I don’t. We may still be doing a lot of dumb things, but we’re an awful lot smarter than we were 80 years ago.

Yglesias responds to this thus:

Kevin’s right. The right-wing advocates of no bailout and “spending freeze” are, in essence, calling for a return to the Hoover-Mellon policies that had disastrous results in the past. The nature of those results is spelled out in the chart. What people are living through today is no walk in the park, but it’s vastly better than the alternative.

This is an extremely dishonest use of the qualifer ‘in essence’. (spending freeze + no bailouts) does not equal (no bailouts + tax increases(!) + higher interest rates + reducing the supply of money(!!!) + higher tarrifs). There is not a lot of enthusiasm for protectionism on the right, and just about no one is wondering why the fed isn’t pursuing a more contractionary monetary policy. The Hoover-era response to the depression and the response to our current troubles urged by Republicans and right-wing pundits are not the same. They are not essentially the same. They are not really even that similar. These ideas are bad enough as they are. Why lie about them?

I love the smell of populism in the morning.

I’m not as worked up about the AIG bonuses as everyone else seems to be. Sure, I’d rather the employees at AIG didn’t get the money. Indeed, it seems pretty clear to me that AIG is the biggest bad guy other than the ratings agencies in this whole mess. As King Felix points out, we bailed them out because their position as a huge net seller of CDS contracts made them an ideal vehicle through which to prevent that market from blowing up, not because we like them, or because they are in any sense deserving of taxpayer funds. Their position in the CDS market also means that they were essentially selling insurance to the rest of the financial system against a system-wide disaster, and they clearly did not have anywhere near the reserves needed to cover that bet. Opinions differ as to whether this was criminal, but it was very clearly reprehensible.

All that said, we’re not talking about a huge sum of money relative to what we’ve paid them, and there doesn’t seem to be a straightforward way of getting the money back, thus the proposals to enact a retroactive tax targeted to these bonuses at AIG. That’s a messy business to be involved in. I’m not necessarily opposed to it, and perhaps I’d vote for it given the information I have now, but the stakes are low enough and the downsides plausible enough that I can’t really see why I would care that much, one way or the other.

But this, from Megan McArdle, is crazy:

I suspect it would be hard to write a specific tax that applied only to AIG and not, say, to Citibank–and that’s assuming that the Democrats in Congress would want to.  I think it’s safe to assume that if this passes, any banks that possibly can will rush to return bailout funds to the Treasury.

First, the premise is simply wrong. One of the proposals being discussed would apply to employees of firms in which the government has at least a 79% stake, which would only apply to AIG. But leaving that aside, how could it possibly be ’safe to assume’ that banks will rush to return bailout funds? These are publicly owned companies. If executives had them give money to the government in exchange for nothing, so as to avoid taxes on their own income, that would be a pretty straightforward way of stealing money from shareholders. I have no idea if that would be legal, but it certainly wouldn’t be feasible from a public relations standpoint.

Terrific stuff from Jonathan Jarvis:

(h/t King Felix)

Mark Hemingway has been kind enough to respond to my earlier post on earmarks. Here’s his comment:

It would help if you were working with an actual definition of what an earmark is — here’s the definition from the Senate rules:

“A provision or report language included primarily at the request of a Senator providing, authorizing, or recommending a specific amount of discretionary budget authority, credit authority, or other spending authority for a contract, loan, loan guarantee, grant, loan authority, or other expenditure with or to an entity, or targeted to a specific State, locality or Congressional district, other than through a statutory or administrative formula-driven or competitive award process.”

Now when they wrote the stimulus bill did they say “$2 billion for a the FutureGen powerplant in Mattoon, Illinois?” No — what they wrote was this: “$2,000,000,000 is available for one or more near zero emission powerplant(s).” Well, guess what — there’s only one “near zero emission” powerplant project in the country, and it happens to be in Mattoon, Illinois. So the language itself, while seemingly not specific, is actually very specific about where this money is going to be allocated. Tom Coburn himself calls the FutureGen provision in the stimulus bill a “cleverly disguised earmark.” So I wasn’t just winging it by singling out “any spending I don’t like that is passed with specific applications in mind.”

Further, if you want to argue that concern about earmarks is overblown relative to the overall budget — fine. This has been pointed out repeatedly, and I actually agree. However, FutureGen would amount to a two billion dollar earmark, the largest in history. And when the President is trying to build public trust in the stimulus package by saying it’s earmark-free when it’s not — that seems noteworthy, no?

Of course, I would have been happy to explain myself if you had just emailed me. But accusing me of intellectual dishonesty and not knowing what I’m talking about seems a bit much. Also, you spelled my name wrong.

For future reference, I’m a perfectly reasonable guy who’s more than willing to dialogue with someone who doesn’t agree with me.

OK, last things first: I can see why Hemingway (my spelling is awful, but it can be corrected) thinks it would have been better for me to contact him for a clarification first; he writes for NRO, which is a very high traffic site, and is thus prominent enough that people will generally respond when he calls them out by name. For those of us who get a few hundred hits on a very good day, however, things look a little different. From where I’m sitting, widely read bloggers are like any public figure; it’s all well and good to discuss their ideas where they merit discussion, but one can’t expect any sort of dialogue. So I’m very grateful that Mark has responded to my criticism, but, in my experience, it’s not something I could have expected ahead of time.

Now, on to the substance. This happens very rarely, so pay close attention: I was actually somewhat wrong about this. BUT, not for the reason Hemingway suggests, which I don’t think does the trick. I am by no means trying to toe a hard line about literal interpretations about such things. For one thing, it would simply be wrong to use the above definition literally, since most defense spending would fit the bill, yet no one counts all defense spending when tallying the size of earmark spending. (We spent ever so slightly more than $18 billion on defense last year.) So if it were the case that legislators had been shoveling money to pet projects through explicit earmarks, and had just now come up with this sort of trick to satisfy the prevailing anti-earmark mood, it would be entirely fair to say that these were just “cleverly disguised earmarks”.

But there is nothing clever at all here, because this sort of provision has always been around. That is, legislators have been directing money to specific projects with both explicit earmarks and general criteria that only one project can meet all along. Insofar as people were distinguishing between these two sorts of provisions, and reserving the term ‘earmark’ for the former up to this point, it would hardly be fair to call it a semantic quibble now that everyone is up in arms against earmarks.

On the other hand, it turns out that some people were already using a definition of ‘earmark’ that explicitly included this sort of thing. From the OMB:

Earmarks Include:

1. Add-ons. If the Administration asks for $100 million for formula grants, for example, and Congress provides $110 million and places restrictions (such as site-specific locations) on the additional $10 million, the additional $10 million is counted as an earmark.
2. Carve-outs. If the Administration asks for $100 million and Congress provides $100 million but places restrictions on some portion of the funding, the restricted portion is counted as an earmark.
3. Funding provisions that do not name a recipient, but are so specific that only one recipient can qualify for funding.

My impression from a quick bit of poking around is that no one applies that last standard very rigorously, but something as blatant as the power plant Hemingway cites would definitely fit the bill. He still overstates his case; plenty of people could honestly say there were no earmarks, because they were honestly using a different, but also widely accepted definition. But it is perfectly reasonable to contend that this is an earmark. So: Mark Hemingway, I apologize.

The general point still stands. Most of the complaining about earmarks - a lot of what’s in that AP article, for instance - is predicated on the notion that any wasteful spending constitutes an earmark, which is just plain wrong, and springs, I think, from McCain’s vagueness on the subject, as I discussed earlier.

I’ve been reading a lot of bizarre complaints that the administration is pulling some sort of lawyers trick by claiming that there are no earmarks in the stimulus bill, because there is lots of wasteful spending in it. Perhaps most vocal on this point has been Mark Hemmingway:

“There Are No Earmarks In This Package” [Mark Hemingway]

If you want to play semantic games, you might be able to claim that statement is true. But to anyone who’s being honest with themselves, that’s simply a falsehood.

Then the AP weighed in with what they call a ‘fact check’ which in this case means - as it so often does - ‘poorly reasoned implications check’. A subtle clue to their verdict is in the title of the piece, “Obama has it both ways on pork”:

President Barack Obama had it both ways Monday when he promoted his stimulus plan in Indiana. He bragged about getting Congress to produce a package with no pork, yet boasted it will do good things for a Hoosier highway and a downtown overpass, just the kind of local projects lawmakers lard into big spending bills.

…

OBAMA: “I know that there are a lot of folks out there who’ve been saying, ‘Oh, this is pork, and this is money that’s going to be wasted,’ and et cetera, et cetera. Understand, this bill does not have a single earmark in it, which is unprecedented for a bill of this size. … There aren’t individual pork projects that members of Congress are putting into this bill.”

THE FACTS: There are no “earmarks,” as they are usually defined, inserted by lawmakers in the bill. Still, some of the projects bear the prime characteristics of pork - tailored to benefit specific interests or to have thinly disguised links to local projects.

The scare quotes are presumably there to do the work of Hemmingway’s ‘if you want to play semantic games’, as well as to get me grinding my teeth about scare quotes. Basically, the claim is that while some dictionary somewhere might think that ‘earmark’ refers to something fairly specific, we all know that when John Q. Public says ‘earmark’, he means ‘any spending I don’t like that is passed with specific applications in mind’. This is stupid. For one thing, John Q. Public doesn’t use the word ‘earmark’, or at least he didn’t until John McCain started shouting about them on the campaign trail. And up until that point, the people who did use the word ‘earmark’ used it to refer to earmarks, which worked out very nicely for everyone.

But is Obama taking advantage of a misunderstanding? Well, here he is discussing it with McCain in one of the debates:

Obama points out that there were only $18 billion in earmarks in last year’s budget. They should be reformed, yes, but it’s hardly a central piece of the fiscal puzzle. McCain acknowledges the $18 billion figure but says that they’ve been increasing rapidly, so they’re still a huge problem. This suggests that he’s using the term to refer to earmarks. Later he claims that there is a lot more than $18 billion in pork, suggesting that he’s changing the subject, or that he doesn’t know what earmarks are after all. But the figure for Obama’s earmarks which he keeps repeating again suggests that he does know what earmarks are.

The truth is that earmarks aren’t just a tiny percentage of overall spending, they’re a tiny percentage of awful, wasteful spending. And not all earmarks are particularly bad. The process is bad, and encourages pork, but fixing that problem would not be near the top of any sane budget hawk’s to-do list.

Still, after all the fuss, it was politically inevitable that Obama would try to steer clear of earmarks, and brag about it when he did. The cliff notes of that fuss would go something like this:

McCain: We need to deal with these terrible earmarks!

Obama: Dude, earmarks aren’t so hot, but then, they aren’t -

McCain: GODDAMMIT! We need to deal with these fucking earmarks!

So now Obama produces a bill with no earmarks, and people are calling it a hoax because it hasn’t rid us of wasteful spending. Sorry, Mark, but knowing what the hell you’re talking about is a semantic game you need to play more often.

Let’s play a little financial meltdown game. See how many of the blanks you can fill in (you needn’t bother with the blanks standing in for numbers):

C_Os [Collateralized ______ Obligations] are diversified investment pools of _____ that issue their own securities with the underlying ______ as collateral. Several tranches of securi­ties with different seniorities are usually created, each with risk and return characteristics that differ from those of the underly­ing ______ themselves.

What attracted underwriters as well as investors to _____ C_Os was that the rating agencies, in a very accommodat­ing decision, gave the senior tranche, usually about 75 percent of the total issue, an investment-grade rating. This means that an issuer could assemble a portfolio of ______ yielding ___ percent and sell to investors a senior tranche of securities backed by those ___ at a yield of, say, ___ percent, with pro­ceeds equal to perhaps 75 percent of the cost of the portfolio. The issuer could then sell riskier junior tranches by offering much higher yields to investors.

The existence of C_Os was predicated on the receipt of this investment-grade credit rating on the senior tranche. Greedy institutional buyers of the senior tranche earned a handful of basis points above the yield available on other investment-grade securities. As usual these yield pigs sacrificed credit qual­ity for additional current return. The rating agencies performed studies showing that the investment-grade rating was war­ranted. Predictably these studies used a historical default-rate analysis and neglected to consider the implications of either a prolonged economic downturn or a credit crunch that might virtually eliminate refinancings. Under such circumstances, a great many _____ would default; even the senior tranche of a C_O could experience significant capital losses. In other words, a pile of junk is still junk no matter how you stack it.

…

Although the potential return was ____ basis points annually in excess of U.S. Treasury securities, the risk involved the possible loss of one’s entire investment.
Motivated by self-interest and greed, respectively, underwrit­ers and buyers of junk bonds rationalized their actions. They accepted claims of a low default rate, and they used cash flow, as measured by EBITDA, as the principal determinant of under­lying value. They even argued that a well-diversified portfolio of _____ was safe. As this market collapsed in ____, ____ were trans­formed into the financial equivalent of roach motels; investors could get in, but they couldn’t get out. Bullish assumptions were replaced by bearish ones. Investor focus shifted from what might go right to what could go wrong, and prices plummeted.

If you’ve been doing your homework, you probably think this test was pretty easy. The passage is clearly about CDOs (Collateralized Debt Obligations), particularly the kind based on subprime mortgages. And you’d have to have been living in a cave not to know that a lot of people “even argued that a well-diversified portfolio of shitty mortgages was safe.”

Funnily enough, though, you would be wrong across the board. Well, not wrong exactly. Filling in the blanks that way does give you a nice, concise summary of our recent woes. But the original author of the passage filled the blanks in differently, because he was writing in 1991 about the junk-bond market of the 1980s.

A lot has been made of the fact that CDOs are a very new product, and this is technically true. But as the above passage demonstrates, there is nothing at all new about the basic structure. Nor is their anything new about ratings agencies attributing magical powers of risk-free revenue creation to secruties so structured. (OK, to be fair, these were mere senior tranches; who could have predicted that even super-senior tranches were vulnerable?) That nobody thought there was something odd about the investment-grade free lunch already stuck me as fairly suspect; I can’t say I’m impressed that the banks were using health-code violation case files as a cookbook.

Which is not to say that I think there is anything wrong with CDOs, CBOs, CDSs, junk bonds, or securitizing mortgages that never should have been issued. I know a lot of people are very angry at some of these financial innovations, and a few of those angry people even know roughly what these things are. And I’m certainly open to an argument that there is something fundamentally wrong with some of these things. But, for now, the moral of the story once again seems to be that the ratings agencies are a disaster, and the way that they’re structured guaruntees that they will remain a disaster. They were fooled by CBOs in the 80s, and now they’ve fallen for precisely the same trick. I’m pretty sure our last president had a clever saying about that sort of thing.

(the original - sans blanks - of the passage above)

(more…)

The WSJ ran an editorial the other day arguing against the New York Fed’s proposal to create a central clearinghouse for credit default swap transactions. I have nothing to say about the issue, other than that they seemed to be attacking the specifics of the proposal, without really addressing the value of having some sort of central market for these derivatives. More interesting to me, though, was this:

If regulators learn nothing else from the housing debacle, they should recognize that their system of anointing certain firms to judge credit risk is structurally flawed and immensely expensive for investors. As Columbia’s Charles Calomiris has explained on these pages, one reason the Basel II standards for bank capital failed is because they subcontracted risk assessments to the same ratings agencies that slapped AAA on dodgy mortgage paper.

This is something that had been bothering me for a while: why is our financial system organized to ensure that everyone has to care what these three big firms think? I was guessing that this was very bad, but I was totally unqualified to make that assesment, so I turned to the Enlightened Despot’s brand-new in-house finance expert, T. Ballgame. Rather than writing up something pretty, here are a few exerpts from our email exchange, revelaing my raw ignorance, and the fact that he knows about this stuff off the top of his head when I bother him in the middle of the night:

Me: I could see why a million little shops analyzing debt and selling their analysis could make sense. But what’s the point of a few big firms whose opinion is treated like gold. I mean, with anything else - stocks, cocaine, what have you - you can’t just point to an authority who says how good it is, you have to figure it out. And if you’re right you make money.

Also, I’m aware that the government has to take someone’s advice as gospel for minimum asset rules for banks or whatever, and that’s clearly a legit problem. But what is the point of them for the private sector. Why are their opinions considered so relevant, such that people get to act all self-righteous and outraged when it turns out they’ve been napping?

T. Ballgame: The big point I can probably help you with on their necessity (or, let’s be honest, their perceived necessity - their rating function is by no means a real market necessity, everyone can do their own damned homework if they wanted) is that they basically set the initial market for the debt they rate.  Yes a bond market sets prices on a daily basis afterwards, but when you first issue a new security, it basically needs to have a rating BEFORE it ever comes to market from one of the agencies.  Why?  I don’t even think it’s law/regulation/whatever, it’s just that that was the way things were done for awhile so that’s how it stayed.  By now, all sorts of pension funds and such have rules about what types of ratings they are allowed to buy (stupid).  The only legitimate argument is that the issuers of debt provide them with material information that the broad market doesn’t get which puts them in a position of authority - I still think this is dubious.

Of course passing judgment before the market does is why the ratings agencies look so stupid right now.  Before all this securitized debt hit the market, they gave it AAA ratings and such and now the secondary market has priced it as shit.  But the point is, if you want to issue debt, they were basically the gatekeepers for quite awhile.  You couldn’t even tap the debt market unless you went through them.  You’d have to research the history of it to find out why.

Same thing for asset rules with banks.  It’s just an evolution of regulation over time more than any real financially based reasons.  I mean, most investment regulation dates back to 1930/1940 until Glass-Steagall came into play in the late 90s.

Me: ok, cool, that’s helpful. But it sounds like you’re endorsing my uninformed notion that this is a pretty shitty set-up. If everyone were doing their own homework, and relying on all sorts of private research, not just the ratings of 3 firms, wouldn’t that be much healthier? I mean, if a bank sets-up an IPO for xyz.com* and the stock falls 50% the first day, people will say that bank did a shitty job, and maybe use a different bank when they’re ready to go public themselves. But when Moody’s and Co get something wrong, capitalism has failed and the apocalypse is surely nigh. How is that a good thing.

On a side note, I imagine that the same facts that make their ratings so important must also be making them more likely not to give a shit. If everyone has to rely on your ratings, what’s the incentive to get them right?

T. Ballgame: I am endorsing you’re notion that the agencies are shitty.  Smart investors never relied on them.  The people who needed to get their debt rated were the very ones paying the rating agencies to rate their debt…their pay structure incentivised corruption, and somehow people are shocked when that’s what happened.

So, down with the big rating agencies!

Our finance expert blogs full-time over at the WhoDey Revolution, an outfit dedicated to creating change from the ground-up, rather than the top down, in the Cincinatti Bengals’ organization. This, I admit, is an odd qualification, but in the not-so-distant past, he was on Wall Street playing God with untold millions, or whatever it is those people do. We’re lucky to have him.

* the outlandish arbitrary web site name I originally printed actually existed, and was accidentally printed in link form. I’ve delinked it, and made it more generic.