By Donald Wessel
The Wall Street Journal
May 29, 2008
Before we replace angst about housing, mortgages and credit markets with anxiety about rising oil prices, consider what we've learned in the past several months. We had a housing bubble; that's now obvious. But how did it happen? Why was its bursting so painful? Without answers, we can't hope to reduce chances of a repeat.
Boil it down to the three R's: rocket scientists, regulators, and ratings agencies.
The rocket scientists are the wizards of Wall Street who invented securities that supposedly dispersed risk widely but actually created much more leverage than proved wise.
There is a good case that the savings-and-loan mess of the 1980s was made in Washington, the inevitable result of government deposit insurance that led to tails-you-lose, heads-I-win banking. The current mess was made on Wall Street.
A bubble so large also required aggressive mortgage originators, imprudent home buyers and myopic investors. But it wouldn't have been as bad if not for the paper factories that sliced up individual subprime mortgages and assembled the pieces into securities, each with its own acronym, that were deemed safer than the underlying loans. They behaved as if they were taking a little poison and diluting it in a big reservoir; instead, they poisoned the entire water supply.
A lot of risk wasn't dispersed, as we now know. It ended up in banks like Citigroup and UBS. To the extent it was dispersed, that posed a different problem.
"The idea of risk dispersion is nice in theory, but in practice it depends on who it gets dispersed to," says Peter Fisher, a former Federal Reserve Bank of New York official now at money manager BlackRock Inc. "It turned out we weren't dispersing it to strong hands who could hold it through the volatility. Rather, we were dispersing it to weak hands who couldn't hold it, and ended up adding to the volatility."
The cost of delinquency, default and falling house prices often was passed to entities (some linked to brand-name banks) that lacked the financial strength to weather a storm. As the entities couldn't bear the burden for long, they had to sell mortgage-linked securities into a hostile, illiquid market, pushing down already depressed prices.
In a modern capitalist system, regulators provide guardrails to keep markets from driving the economy off a cliff. The regulators failed. Whether regulators should or could have restrained innovation on Wall Street or prohibited business deals between consenting, sophisticated adults is a tough question.
But regulators failed to protect unsophisticated consumers from mortgage loans that they simply couldn't afford or didn't understand; they're now fixing that. And regulators misunderstood the risks that banks were taking and failed to stop lenders from lowering standards too far in their frenzy to attract business; fixing that will be tougher.
Among their many failings, the regulators allowed lenders to make a fundamental mistake: To lend not against the borrower's cash flow and income, but instead to lend against the seemingly inexorable increase in the value of the collateral. Mortgages were made to people who couldn't afford the payments because the lender (or investor) figured that if the borrower defaulted, the house would always be worth more than the loan.
"It is the hallmark of a credit bubble when lenders think that because collateral is going up in price they can ignore the borrower's ability to pay," says BlackRock's Mr. Fisher. "Collateral should only be a backstop." When lenders forget that, regulators must step in. "Lenders need someone to prevent them from competing their way to the bottom," he says. Let's put those words on a laminated card and hand it to every banking supervisor.
Then there are the rating agencies, mainly Moody's and Standard & Poor's. "Credit-rating agencies assigned high ratings to complex structured subprime debt based on inadequate historical data and, in some cases, flawed models," the Financial Stability Forum, a collection of regulators and central bankers, said in an April report. "As investors realized this, they lost confidence in ratings of securitized products more generally."
The flaws of rating agencies are a mélange of conflicts of interest, misleading grading systems that classified complex securities as if they were much like simple corporate bonds and a backward-looking approach that proved particularly useless. They were the enablers. They are atoning and changing their ways, as they should. Their business model will change; government oversight will be strengthened.
But investors who relied on the rating agencies -- particularly supposedly sophisticated pension funds and other institutions -- are at fault, too. Rating firms became a crutch for investors who simply didn't want to spend the time and money required to be prudent investors at a time when low interest rates had everyone reaching for higher returns without contemplating the higher risks.
A little "back to basics" in banking and investing would go a substantial way toward avoiding a repeat of the Panic of '08.
