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.
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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.
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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.