Government Errors are not Errors—So there

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    Do not think about, write about or deal with  human behavior without determining the effects of incentives. It’s not their money, of course they’ll waste it.

      Wherein we see how government regulatory agencies didn’t regulate. There’s a surprise for you.

The Big Short Misleads on Ratings Agencies
Government Regulators Crippled the Market’s Self-Regulation
Robert P. Murphy

The Big Short has captured rave reviews, not just from conventional critics but also from the likes of Paul Krugman. By featuring Hollywood heavyweights Ryan Gosling, Brad Pitt, Christian Bale, and Steve Carell, this exposé of the housing bubble and ensuing financial crisis was sure to gain attention. For his part, director Adam McKay does a great job keeping the plot moving forward while accurately conveying the essentials of the Wall Street and commercial lender shenanigans.

The Big Short leads viewers to believe that shortsighted greed is the ultimate explanation for why the ratings agencies gave their blessing to dangerous products.

The movie was surprisingly entertaining, given the dry subject matter, and I was impressed at the level of detail. Furthermore, fans of free-market economics should cheer any movie that can make short-selling speculators, of all people, look cool.

But the movie blames market forces without looking to the role government intervention played. FEE.org’s Jeffrey Tucker points out, for example, that The Big Short fails to mention the role of the Federal Reserve and the various federal government policies that promoted unsound mortgage practices. I’d like to focus specifically on the role that the ratings agencies played.

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     The unsound mortgage practices included no or low down payments, low interest at the beginning and increasing quickly to much higher rates, and etc. These policies made dwellings available to those who couldn’t afford them. Never a good policy which is why it was a government policy.

Derivatives and the Ratings Agencies

The Big Three credit ratings agencies are Moody’s, Fitch, and Standard & Poor’s, which together account for some 95 percent of the market. They were an essential part of the housing boom and bust. To understand their contribution, we need briefly to review the historical context.

From 2002 through the end of 2005, various indices of US house prices soared, with some key cities enjoying double-digit annual gains. Naturally, institutional investors wanted a piece of this action. After all, houses provide a flow of shelter services (or rental income, if the owner brings in tenants), so if the market price of the asset is consistently rising at a rapid pace, the opportunity appears wonderful.

The problem is that many fund managers have rules limiting the riskiness of the assets they purchase for their portfolio. Any particular parcel of real estate can be quite volatile in price, and even the mortgage issued to the buyer (with the real estate as collateral) is risky, because the borrower might lose his or her job and default on the monthly payments.

The solution to these problems was the mortgage-backed security (MBS). Rather than selling investors particular mortgages, an MBS might be built of portions of thousands of mortgages drawn from across the country. Furthermore, different layers or “tranches” of the MBS could then be sold to different investors, depending on their risk appetite. If we picture the MBS as a bucket being filled with monthly mortgage payments from thousands of homebuyers, then the bottom tranche is the safest. As we move up in the bucket, the layers (or tranches) get riskier, because those investors only get paid if a high enough proportion of the homebuyers make their monthly mortgage payment (and hence fill the bucket to that height).

By increasing the number of mortgages in the pool, and by adjusting the circumstances under which a particular tranche will not be paid, the Wall Street firms were able to present a very diversified, seemingly safe asset for institutional investors. Indeed, the supposedly independent ratings agencies would sign off on the safest of these derivative products, bestowing the highest rating, AAA, even though (with hindsight) it is obvious that these financial instruments were quite vulnerable.

What Went Wrong?

The Big Short leads viewers to believe that shortsighted greed is the ultimate explanation for why the ratings agencies gave their blessing to dangerous products. In one scene, a woman working for a major agency says that if her company doesn’t grant a triple-A rating, the Wall Street bank (which is their customer) will simply take the financial product in question down the street to a competitor to get a high rating from them.

Fans of free-market economics should cheer any movie that can make short-selling speculators, of all people, look cool.

This can’t be the full story. After all, why doesn’t every financial product get a triple-A rating? Why doesn’t every company bring its corporate bonds to, say, Moody’s, and demand a triple-A rating or else they’ll walk down the street to Fitch?

If the ratings agencies were completely off base, making ridiculous announcements that had no relationship to the underlying facts (about the solvency of the debt issuer, etc.), then the financial community would stop taking their evaluations seriously. So the reality can’t be quite as crude as the movie suggests.

Models Behaving Badly

Part of the explanation is that the derivative financial products were very complex, so most people in the financial sector had no idea how to price them. It took sophisticated computer models, designed by physics PhDs, to evaluate the riskiness of a particular mortgage-backed security. As the movie so beautifully captures, there was a period where some of the experts knew the ratings agencies were giving nonsense scores for these products, but the rest of the market was oblivious. The underlying complexity enabled the illusion to persist, because people assumed that the magic of diversification — by building a pool of mortgages from across the country — removed the risk.

More specifically, the “quants” designing the computer models made a huge intellectual error. When predicting defaults on mortgages, an obvious factor is the real estate market. If the market is booming, then few buyers should default. Even if someone loses his job and can’t afford to make the monthly payment, he can simply sell the house — at a higher price than he originally paid — and pay off the note. But if the market crashes, then many people will be stuck. They will be trapped in a house that they can neither afford to keep nor afford to sell, because they owe so much more than the new market value of their property. Even if the noteholder evicts the delinquent occupants, the default still stings, because selling the house (in the depressed market) will not recoup for the lender the funds originally advanced to the borrower who bought the house.

Thus, we see that a crashing real estate market could trigger a wave of mortgage defaults. The computer models used by Moody’s and others were perfectly aware of this possibility. And they used reasonable historical statistics to estimate the likelihood of real estate crashes of various magnitudes.

However, these models made a crucial mistake: they assumed real estate markets were local.

For example, if history suggested that there was a 1-in-10 chance of home prices in a major city falling by at least 5 percent in a year, then the computer models concluded that there was only a 1-in-1,000 probability for home prices to fall by at least 5 percent in Miami, Los Angeles, and Las Vegas in the same year. These were considered independent real estate markets, and so an unlikely event hitting one of them would be uncorrelated with unlikely events hitting the other cities. But this assumption proved faulty, because (I would argue) the same structural forces that produced an unsustainable boom in Miami also spawned a bubble in Las Vegas and other cities.

The Role of Regulation

Finally, consider the role of government financial regulation. There are various rules specifying minimum levels of safety for assets satisfying capital requirements of depository institutions. Yet, the government rules can’t specify merely the rating; they must also specify the acceptable issuers of such ratings. A commercial bank can’t hold a portfolio consisting entirely of bonds issued by cryogenic freezing firms; that would be far too risky in the present environment, in which the government supposedly keeps depositors and investors “safe.” But what if the president of the commercial bank hired his cousin Fred to type up, on official letterhead, “These cryo bonds are all AAA rated”? Would that make a difference?

The answer, of course, is no. The government and Fed’s financial regulations force firms to give their business to the industry leaders in the credit rating business. In other words, it’s not enough for the federal government to say, “A bank must satisfy certain capital requirements relating its equity to risk-weighted assets.” No, the government must go further and specify which agencies are allowed to provide the ratings that are used when calculating “risk-weighted assets.” This crucial fact is a large part of why, even after the Big Three performed miserably during the housing bubble years, they are still in business.

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     In other words, if you’re government-sanctioned and supported agency, you can’t be wrong not matter how wrong you are.

In contrast, in a free society, there would be no coercive regulations imposed top-down on the financial sector. If a bank wanted to attract depositors, it would need to convince them that its assets were sound. There would still be a role for ratings agencies, so that investors could buy bonds more knowledgeably, but if there were a huge screw-up — where a particular ratings agency gave horrible guidance on an entire class of assets — then that company would be heavily punished. The rest of the market could quickly adapt and no longer treat that agency’s pronouncements as authoritative, because there would be no regulatory code declaring them so.

The Big Short is an entertaining movie, and it accurately describes important aspects of the housing bubble, but the film might give viewers the erroneous impression that private greed is the ultimate explanation. In reality, government intervention crippled the market’s normal mechanisms for limiting mistakes on the front end and heavily punishing mistakes on the back end.

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   Government-approved entities making egregious errors knowing full well all they had to do to make things better was to engage in political buck and wing.

    Do not think about, write about or deal with  human behavior without determining the effects of incentives. It’s not their money, of course they’ll waste it.

Government Job or Respect–Which’ll It Be?
Cheerio and ttfn,
Grant Coulson, Ph.D.
Author, “Power Teaching: How to Find Someone to Teach Your Child when the Education System has Failed.
Cui Bono–Cherchez les Contingencies

   There are new allegations that Bill Clinton has affairs with “thousands of women>’ I would argue that “affair” is a misnomer for something lasting a few hours. Too bad we don’t know the real numbers so we could tell if Kennedy or Clinton was the winner.

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