ataxingmatter

More on the Mortgage Mess

As our banking giants engaged more and more in speculation, and as the shadow banking system saw a way to make money off of people's bad financial decisions by betting against subprime loans, the financial crisis took off.  So redressing the problems that caused the crisis shouldn't overlook mortgages.

The Treasury has now come out with a "plan" for addressing the government sponsored enterprises Fannie and Freddie, which played a role in the crisis though were not the drivers of the subprime origination mess.  The plan, Reforming America's Housing Finance Market: A Report to Congress (Treasury and Housing and Urban Development, Feb. 2011), claims that it will "reform America's housing finance market to better serve families and function more safely in a world that has changed dramatically."  It also claims that it is intended to limit the government's primary role to "robust oversight and consumer protection, targeted assistance for low-and moderate-income homeowners and renters, and carefully designed support for market stability and crisis response."

Both of those claims are worrisome.  First, the alternatives proposed seem better designed to serve the financial services industry than famililes.  Not only is there still no provision for mortgage modification in bankruptcy, but securitization is intended to "continue to play a major role in housing finance", even though the securitization process has brought a nightmare of foreclosure mills and uncertainties about who owns debt and has the right to foreclose.  While the Administration walks the GOP-favored walk of decreasing government/increasing private markets, it nonetheless leaves government as the one that backstops the private mortgage market, retaining the possibility of private gains and social losses.

Second, the statement that government will be limited to "carefully designed support for market stability and crisis response" means that the government will continue to backstop the securitization losses, as Yves Smith at Naked Capitalism puts it in The 7 Things Really Wrong with the Treasury's GSE Proposal:

Of the Treasury three proposals, the last is the same as one advanced by the big guns, from the Mortgage Bankers Association, the Fed (both the New York Fed and the Board of Governors), the Financial Services Roundtable and Mark Zandi of Moodys. This alternative preserves too many bad elements of status quo ante, in particular significant and largely hidden subsidies for banks, for anyone to hail it as reform. Although each proposal has some distinctive wrinkles, all call for the creation of “private” entities that would provide insurance to mortgage backed securities that would then be reinsured by the government, with a full faith and credit guarantee.

What is to prevent huge public losses?  The proposal relies on a guarantee fee and higher bank capital requirements.   This isn't good enough because it builds too much on the status quo ante.  Yves Smith provides her list of the Treasury proposal's problems:

1. The most pressing problems related to the crisis of abuses in the housing securitization markets outside of Fannie and Freddie are still not addressed
2. The plan continues to use a poor tool to address housing goals, by focusing on mortgage financing.
3. Reliance on the old 30-year fixed rate prepayable mortgage is outdated and fails to address today's markets.
4. Continued use of the private (owners of the entities)/public (backers of the entities debts) structure is fated to suffer the same problems with increasing risk and lobbying as Fannie and Freddie
5. This just props up the housing market; it isn't really a help to consumers.
6. The new entities will continue the conflicting roles of the pre-crash Fannie and Freddie of propping up liquidity and making credit decisions.
7. There's nothing to keep these new entities from being too big to fail.

Tenneco CEO's Wall St. Journal on "American Capitalism"

Gregg Sherrill, the CEO of Tenneco, Inc., seems to think that Capitol Hill and the White House are "bashing" the "entire free enterprise system"--saying that the business world has "taken a pounding on Capitol Hill and at the White House" but except for the copmanies that were part of the "easy credit and disguised risk that so spectacularly collapsed", American business "has nothing whatsoever to apologize for."  Speaking up for American Capitalism, Wall. St. Journal Op-Ed, Jul. 15, 2010, at A17. 

But the op-ed is a straw man argument tilting at windmills. 

First, Sherrill notes a study cited by The Economist that finds that most Americans "prefer the free enterprise system to any collectivist alternative."  Reading that, you'd think that there was a major debate in this country about switching from capitalism to socialism.  But there's no such thing going on.  Nobody is pushing a socialist agenda, in which the government would permanently take over means of production.  Many politicians are reluctant to speak out strongly for the traditional American values of a market that is regulated for the common good rather than allowing corporate titans (and their wealthy elite shareholders) set the laws to suit themselves.  In fact, the push for the last four decades (dating from Reagan's swearing in) has been the opposite--to change America's system of tempered capitalism to one of no-holds-barred "free markets" along the lines espoused by the Chicago School's Milt Friedman, who didn't care much about democracy but did care a lot about starving government and letting capital have a free reign no matter what the detriment to ordinary folks.

Second, Sherrill himself explicitly acknowledges that business cannot function "without the appropriate regulation and incentives government can provide."  That is what tempered capitalism is all about--encouraging people to establish and run businesses but restraining the more harmful aspects of rent-seeking profitmaking.  Key to decent democratic government is the role of government in protecting consumers from overweening corporate power and the public interest from the kind of reckless private greed that can lead to the "socialization of losses, privatization of gains" that we have seen in the causes of our Great Recession.  Forty years of Reaganomics bred negative attitudes towards government regulation fostered within government itself and gave brutal, greed-is-good capitalism a chance to wreak havoc on the economy and on the lives of vulnerable Americans not in the elite upper quintile.

But most of the rhetoric in the piece is straight from the "starve the beast", free marketarian guidebook of the Cato Institute and other think tanks pushing the Chicago School version of "free enterprise."   It uses the rhetoric of "the moral case for free people and free markets."  It argues against enlarging government "in a way that would fundamentally shift its level of involvement in our overall economy."  Yet Sherrill knows that there is no such thing as "free" enterprise--since without contracts and social networks and societal restraints, his corporation would be nothing but a local business, involved in a dog-eat-dog world with everybody enabled to act like the Mafia and exact whatever "protection payments" brute force permitted.  He also knows that "free market" is not synonymous with "free people"--in fact, there is a good deal of tension between the two terms, since a people is only free when the democratic freedoms that underlie our way of life are not subordinated to the power of megalithic market enterprises. Unrestrained markets with monopoly players are antagonistic to genuine human freedom:  labor is treated as quasi-property (remember Lochner) and wealth is treated as quasi-god. 

And finally, he knows that there is no consideration in the offing for an enlargement of government in a way that would "fundamentally shift its involvement in the economy."  First, government is inherently "involved in the economy", since government must make decisions about revenues, expenses, programs and public interest every day, and every decision about taxing, spending, punishing, rewarding and encouraging behavior has economic consequences.  second, corporations like Tenneco push avidly for government to fundamentall shift its involvement in the economy with every lobbying dollar spent, which is intended to influence government to enact business and corporate-favorable programs.  Subsidies of the oil industry that exist right now--that's government involvement in the economy.  And the oil companies are fighting to retain all of them.  Implicit and explicit guarantees of the financial system--that's an incredible involvement in the economy, providing cheap funding for banks.  And investment banks clamored to be eligible for the largesse, even as their version of casino capitalism spun out of control.  So while the rhetoric warns about government involvement, the reality cozies up to government subsidies and merely frowns when government involvement means acting to balance the relationship between business and consumer, as in the fight against the consumer protection agency provisions of the financial reform legislation and the intensive lobbying by the auto dealer industry for an exemption (i.e., for permission to go on ripping off auto consumers as they have frequently been doing).

But the most pernicious part of Sherrill's op-ed is his warning that "people will buy into the false perception that government can fix our current crisis, which will lead to policies making our economic recovery more difficult."  Business can't fix the crisis alone, because business as usual has become too short-sighted and too intent on rentier profits.  However, government, with economic stimuli targeted to those at the bottom who are hurt the most, can do much to avert the harm of the Great Recession for its people and to provide a path for a sustainable economy out of the recession.  But this blather about fearing that people will depend too much on government covers an agenda on the right to make sure that government isn't there to make a difference for the people, so that Big Business can continue its self-interested focus without the kinds of restraints that make democracy and the economy sustainable.

Buyer beware.  Much that comes in the guise of setting the record straight about American capitalism is just more of the same attempt to mislead Americans into distrust of their government and reliance on Big Business instead. 

Senate GOP kills jobs bill (again); House passes financial reform bill; Senate puts off til after July 4th recess week

Shaving a few billion off the deficit more important than preventing a deeper recession (and probably deeper deficit)--the Senate GOP stands on ideology even if it means sinking the ship and everybody on it.S  enate GOP Again Kills Jobless Bill, New York Times, June 30, 2010. 

These are those same Senate GOP members who mostly are avid supporters of cutting revenues (and increasing deficits) by giving the ultra wealthy beneficiaries of mega estates a cut in the tax that ordinarily would be taken out of the estate upon transfer, killed the bill to provide unemployment assistance to those millions who have been out of work for 26 weeks and would provide funding for states that otherwise will be laying off thousands of teachers.  The naysaying GOP senators say they are sympathetic with all those ordinary Americans who are losing their jobs or losing their sole means of making it, but they just can't pass a bill like that because it will cost too much money.  It would add $33 billion to the deficit.  The GOP dream of estate tax repeal would cost between $20 and $30 billion; just lowering the amount of tax collected from estates that do-nothing heirs inherit as a windfall would cost about $15 billion. 

The House on June 30th passed the financial reform bill conference agreement, with 19 Democrats joining all but 3 Republicans in voting against the bill. See Financial Overhaul Wins Final Approval in House, New York Times (DealBook), June 30, 2010.  The Senate vote will be delayed until after the July 4 recess.

The overall scheme of the bill is a start on financial regulation, though it leaves much too much out altogether as a result of the long negotiation sessions too influenced by bank lobbyists demanding that they be allowed to continue business as usual.  It also leaves too much discretion to regulators rather than enacting strict limitations on leverage, banning particular risky derivatives outright (like naked credit default swaps, for which there is no justification other than gamblin).  While it requires registration and hedge and private equity funds and some disclosure, it hardly scratches the surface of what should be done with the shadow banking system, which is to acknowledge that these entities exist to get around the rules governing conservative banking and represent a major weak point of the financial system because of their excessive leverage, interconnectedness and size.  Shadow banking entities should be regulated as banks, and banks should be regulated in a way that ends overly leveraged speculation.

Here's the Times' key paragraphs describing the bill:

The bill gives government regulators the authority to liquidate failing financial companies by breaking them apart, selling assets and forcing creditors and shareholders to take losses so that taxpayers do not pay the bill.

The legislation also vastly expands the regulatory powers of the Federal Reserve and establishes a systemic risk council of high-ranking officials, led by the Treasury secretary, to detect potential threats to the overall financial system. It creates a powerful new consumer financial protection bureau and widens the purview of the Securities and Exchange Commission to broaden regulation of hedge funds and credit rating agencies.

The measure restricts the ability of banks to invest and trade for their own accounts — a provision known as the Volcker Rule, for its proponent, the former Fed chairman, Paul A. Volcker — and creates a new regulatory framework for derivatives, the complex financial instruments that were at the heart of the 2008 crisis.

Of course, derivative regulation is markedly insufficient, since only some types cannot be dealt in by banks subject to federal bailout power.  Lincoln's plan to force swaps trading desks out of banks failed because of resistance from the GOP corporatist majority and various Dems worried about Wall Street's profits.  That group misses the point about the crisis--the real economy suffers from financial innovation through derivatives and securitizations that permitted the banks and shadow banks to "manufacture" money by lending and relending based on the same underlying. 

Links for additional documents on both items:

Extenders/unemployment insurance bill:

House rollcall vote on passage of its version of HR 4173 in December 2009 

CBO estimate of revenue and spending under S. Amdt 4402 to HR 5297 (House-passed small business legislation).

CBO (with JCT) estimate of budgetary effects of S. Amdt. 4425 to HR 4213 (tax extenders/ unemployment insurance bill)

Text of S. Amdt. 4425 to HR 4213 (tax extenders/unemployment insurance bill) Download 4213. S. Amdt 4425. text.

Financial Reform Bill:

Conference Report (this is unofficial copy, from a political website named Liberty Center--I'm writing this Wednesday night, so will substitute official copy as soon as available).

Marxist scholar David Harvey on capitalist crises

David Harvey, an academic who studies Marxism at CUNY's Center for Place, Culture and Politics, gave a speech at The Royal Society for the Encouragement of Arts, Manufactures and Commerce in April on "The Crises of Capitalism."  You can follow the speech with an animated cartoon by the Society's RSAnimated.com, at this link. 

It's certainly entertaining.  Does it provide some food for thought regarding the move to globalization with its impact on workers in the developed world, the financialization of the economy with its ready flow of credit til it stopped, and the divergent impacts of the financial crisis on banksters (who continue to make out like bandits) and ordinary Americans (who continue to suffer financial insecurity from the hit to jobs, homes, and pensions)?  You be the judge.

Deficit hawks vs. stimulus supporters: why the government needs to keep spending

Yves Smith, at Naked Capitalism, has a post on the problems created by the current trend to argue for austerity measures to cure the deficit rather than government spending to stimulate the economy.  Deficit Doves: The gift that keeps on giving, Naked Capitalism, June 27, 2010.  Providing an excerpt from Warren Mosler (New Deal 2.0), who concludes that we ought to provide a government job to any able-bodied citizen who wants one to help transition back to a private economy that functions to create jobs, Yves reminds us of the way that mainstream economists (and the prestigious economic journals) favor tales of equilibrium in which austerity measures can bring a wayward budget back under control.  Not really so, she says--the only way to overcome the kind of crisis we are in is through continued government spending. 

[E]ven if the US had no trade deficit, the government would need to run a deficit to accommodate the desire of the private sector to save. The alternative would be that the US would need to go from its assumed trade balance to a trade surplus. That would happen through a fall in prices and wages in its tradeable goods sector (which can happen via domestic deflation, which will make debt burdens worse in real terms, or a fall in the dollar) and/or an increase in productivity so that our exports gained market share.

***

So, if we decide to run government surpluses now, the result is almost certain to be deflation, at best a Japan-type stagnation with high unemployment (and the US has far less social cohesion than Japan does), at worst a deflationary downspiral. But in either case, austerity becomes self-defeating. The value of outstanding debt rises as prices fall and GDP contracts. Default becomes more likely, and as defaults rise, banks become more impaired, investors more cautious, and the downturn can easily accelerate and become self-reinforcing.

Bank Tax: France, Germany and UK, but where's the USA?

On June 23, the big three Euro countries--France, Germany, and Britain--agreed to tax banks directly, "to ensure that banks make a fair contribution to reflect the risks they pose to the financial system and wider economy, and to encourage banks to adjust their balance sheets to reduce this risk."  See Saltmarsh, France, Germany and UK Support Bank Tax, NY Times, Jun 22, 2010; Eddy, Germany, France, UK commit to bank tax, IdahoStatesman.com, Jun 22, 2010; Cf Berlin approves bank levy plan to fund future bailouts, Deutsche Welle, Mar. 31, 2010. 

The tax in the UK (which is also increasing its capital gains tax) will be imposed on banks with liabilities in excess of $20 billion pounds and should raise about $3 billion a year. Saltmarsh op cit.  It will be based on the aggregate amount of riskier liabilities (i.e., liabilities other than Tier 1 capital and insured deposits).  Berlin's Finance Ministry noted that "All three levies will aim to ensure that banks make a fair contribution to reflect the risks they pose to the financial system and wider economy, and to encourage banks to adjust their balance sheets to reduce this risk." IdahoStatesman op cit.

Although the US has ostensibly supported such a tax, we have been notoriously reluctant to impose any real constraints on banks.  The financial reform legislation wending its way through Congress has been watered down, so that both consumer protection and protection of the national fisc have given way to the desire of banks to continue to grow in size so that they can compete globally.  Geithner has indicated that big banks are essential so they can lend to big multinational corporations and so that US banks can "be competitive" with foreign banks.

This competitiveness stuff is nonsense.  What good is it to have a competitive monster that we have to stand behind and whose costs of funds depend in part on an implicit guarantee that the government will backstop its losses?  Why can't a bevy of smaller banks serve big multinationals banking needs?  Sure, it means that funds may be more costly to the banks and that big multinationals may not have as big an advantage compared to smaller firms.  Both of those are GOOD results--we need to think about ways to downsize banks.  I'd prefer Merkel & Levin's proposal for limiting size by setting liability and asset caps but surely we should not continue to refuse to enact good reforms for the sole purpose of letting banks continue to be too big to fail!  A bank tax based on risky liabilities is an excellent way to recoup some funds from banks that benefit from the cost of funds advantage of an implicit government guarantee and at the same time incentivize banks to hold less of such risky liabilities.

Financial System: Countrywide (Bank of America) abuse charge settlement

Bank of America agreed to pay $108 million to settle FTC charges that its subsidiary, Countrywide Financial (acquired by BofA in 2008) engaged in abusive mortgage practices.  Wyatt, Countrywide Pays $108 Million to Settle Fees Complaint, NY Times, Jun. 7, 2010.  The case involved charging excess fees for homeowners in default, such as hiring its own subsidiary to do property maintenance at excessive rates or imposing new charges on homeowners who had been in bankruptcy (where mortgage loans still cannot be modified), and sometimes claiming homeowners were in default when they were not, with all the problems that a default can bring on.  According to the FTC Chair Leiboweitz, “Countrywide profited from making risky loans to homeowners during the boom years, and then profited again when the loans failed.”  Id. 

The money will go to the 200,000 homeowners who had mortgages before the 2008 sale to Bank of America.

Like so much else connected with the mortgage meltdown and financial crisis, this case demonstrates the problem that Congress has still not acted to pass a mortgage cramdown provision that would allow bankruptcy judges to modify home mortgages.  The only reason not to pass such a provision is to protect the profits of banks, and that simply isn't a sufficient rationale. 

Wall Street Lobbyists' View of Financial System Reform

[edited to add link 5/4/10 at 3:12 pm]

Today's Washington Post has an interesting story on the bank lobby's thinking about financial reform.  Klein, Lobbyists fret over legislation to reshape financial system, Wash. Post, May 4, 2010.

Basically, the story line is this (with some added interpretive flourishes of my own, in italics). 

Bank lobbyists didn't like the House bill.  Too tough.  They expected the Senate bill to be better.  Sure, Dodd had a couple of provisions they didn't like, but with Republicans Shelby and Corker making lots of noise about the need for bipartisanship and Dodd trying hard to get a bipartisan bill, there was pretty strong expectation that the bill that came out of that negotiation would be much more favorable to the bankers' positions.  But then something happened.  Senators started worrying about upcoming elections.

(My goodness, what might ORDINARY VOTERS think if the senators don't vote for tough regulation of the banks that caused the Great Recession and the bankers who flew through it with hardly a scrape, while ordinary Americans are suffering high unemployment, stifled dreams, and long-term fears about their financial security, while still paying exorbitant fees for everything provided by banks and getting loans, if at all, only by paying interest at quite a spread over the almost zero rate the bank has to pay to borrow from depositors or from the overly generous FED window.) 

The bill made it out of committee with no amendments.  None.  It was a party line vote (GOP against) but all those expected GOP amendments didn't materialize.  It just took 20 minutes to vote it out of committee and make it possible that there would be real floor debate.

And the lobbyists' response is this:

Instead of getting the provisions the banks don't like loosened, the Senators' thinking about upcoming elections has them adding tougher provisions.  Those provisions are likely to actually impact the banks' profits (their big business in derivatives and proprietary trading, most of it risky, a lot of it used to help banks or others evade regulatory requirements or avoid taxation through some kind of arbitrage) and their "global competitiveness"  and benefit to the American economy (read this as --their ability to do all the risky stuff that big banks in other countries may still be able to do, and if you can't be as risky as the next bank, you won't make as much mone and, after all, what's good for the big banks should be understood to be good for the American economy).

So what's the solution?  Why, the usual deal that lobbyists have been comfortable with over the last few decades--getting inside access to the men who have power to shape the bill in a back room somewhere (and letting them know that working for the lobbyists is their job, not paying attention to the ordinary people who put them in office).  Says one lobbyist interviewed by the Post:

"They've got to get this thing off the [Senate] floor and into a reasonable, behind the scenes" discussion, said one lobbyist. "Let's have a few wise fathers sit around the table in some quiet room" and work out the details.

Maybe, the lobbyists say, they'll even have to accept a banker-unfriendly bill from the Senate, but they can work the Conference Committee when a few players from the House and Senate get together to iron out the differences between the two versions of financial reform--maybe even Barney Frank, who has been pretty critical of big banks lately (they seem to think that he can be influenced to be their best friend forever). 

And if not, then they've got full employment for the next ten years, as they work to persuade Congress to weaken whatever bill is passed (just as they did with the Glass-Steagall Act, where they wheedled and bargained to get exemptions and waivers and eroded the law until the Great Recession was the result).

"I think it's going to be job employment for me for the next decade, undoing some of this stuff," said one lobbyist.....

Beale here:  Now folks, it's pretty revealing when lobbyists have become so accustomed to their privileged access and backroom dealings with politicians --as went on in regards to Cheney's energy discussions, and each of the Bush tax cuts drawn up by a secretive group of GOP without any sunlight (or bipartisansip), for example, and too much with the health care bill as well--that they don't even bother to hide their scorn for the public's views and their hopes for getting that back room deal to go their way.   No wonder Wall Street honchos have been so brazenly arrogant about their "entitlement" to bonuses, their rights to continue proprietary trading and hedge funds and derivatives desks--"doing God's work" says Goldman CEO Blankfein--when they are merely running a casino market to strip as much gold off suckers as possible with their "financial innovations" like synthetic CDOs that made the market many times more volatile than "real" securitizations (which themselves were too easily done for our own good).

This is why I have long been worried about the "safe harbor" for mark-to-market rules for tax purposes under section 475, which lets banks use various types of financial statements to determine their "mark" that sets their income for tax purposes.  It is far too subject to manipulation, and what we have seen is that there are simply no voluntary curbs that will constrain bankers from taking high risks to get the results they want to get to make their own pocketbooks even fatter.

Accordingly, I'm convinced that tough financial reform needs to break up the big banks so that we don't have any that are "too big to fail."  Trying to maintain them big and then monitor the systemic risks they cause is a losing proposition, since their hubris and engineering smarts means they will always try to be one step ahead of regulators so they can make more money.  See, e.g., The Fourteenth Banker, Huffington Post, Apr. 13, 2010 (management banker at one of our megabanks admits to ethical crisis at banks and need to move proprietary trading so that banks get back to supporting America's entrepreneurs).  The Senate should enact a bill with the Lincoln curbs on derivatives and a ban on proprietary trading for investment banks as well as the Kaufman limits on size.  Let the accounting rules fall where they may, by the way, with more, not less, emphasis on taking losses from disrupted markets into account and less, not more, emphasis on mark-to-model accounting.  Make bank regulatory decisions independently based on whatever criteria are important to that. All the other measures--capital reserves, liability limits, consumer protection agency with independent enforcement powers, a systemic review council--are important, but without those real teeth they won't be enough to curb the banks' appetite for outsize bonuses and the risk that they encourage. 

credit rating agencies, tax, and the financial crisis

[edited to include Krugman op-ed and for typos]

Senator Levin's Senate Permanent Subcommittee on Investigations held hearings Friday on "Wall Street and the Financial Crisis: the role of credit rating agencies", third in the series of hearings on the "causes and consequences" of the financial crisis.  The website provides statements of Levin and Coburn as well as those of the various speakers at the hearing.

What shows through all of these hearings is the way financial institutions lost sight of any responsibility to the public interest in their effort to earn quick profits that would translate into big bonuses.  Risky lending strategies promised quicker short term gains, so why not?  selling complex securitization products offloaded the risky loans to clients, so why not?  trading for the bank's own benefit made more money (especially when you could short naive customers) than merely serving as a staid, prudent middleman in normal business deals, so why not?

That mentality carried over to bankers' relationship with the credit rating agencies and to the way the credit rating agency did their deals, especially as more complex products were structured that were less comprehensible to even sophisticated investors.  Pressure from bankers for the "right" rating approach made a difference to the rating agencies' bottom lines, and that pressure generally got what it wanted.  As a result, the securitization "gig" led to  huge profits from the too-ready flow of securitization dollars  for banks and rating agencies.  See, e.g., Levin Exhibit 1g showing doubling of the top three credit rating agencies' revenues from $3 billion to over $6 billion from 2002 to 2007, a period when about $2 trillion in mortgage-backed securities were issued (36% backed by subprime mortgages).

This has significant repercussions for the financial crisis, since the easy availability of triple-A credit ratings meant the continuing flow of easy credit through the hyped-up securitization markets.  But it is also meaningful for tax analysis.

Back when I worked on mortgage securitizations (in the somewhat less heady pre-2001 days), we tax analysts also relied on credit rating agencies in making our analysis of whether a particular security would be treated as debt for federal income tax purposes.  A high credit rating signifies, we thought, that the credit rating agency has done its internal modeling on the underlying assets and concluded that there is unlikely to be a default and that the cash flows on the underlying assets in the securitization are sufficient to service the debt, so that interest and principal payments can be treated as relatively certain to be paid.  Lawyers giving tax advice, in other words, were also relying a great deal on credit rating agency "opinions" to give their own opinions that a security should be treated as debt rather than an equity investment.  That in turn opened the security for investment by pension funds or others who would only invest in relatively "safe" debt and insured the issuer that there would be an interest deduction, rather than a nondeductible dividend or other payment on equity. 

As a result, pressure from investment bankers who set up and sell securities to get the "right" credit rating may not only lead to deception of investors in terms of the riskiness of the loan but also to mistreatment of the security as debt for tax purposes.

And if investment bankers sometimes bullied junior associates to get the "right" tax opinion (which I personally experienced), one cannot doubt that they sometimes (perhaps even more frequently) bullied credit rating agency personnel to get the "right" credit rating. 

But the credit rating agency problems did not just stem from this inherent conflict of interest (that investment bankers who were putting together deals were paying them to come up with a rating that would help sell the deals). They also were hoist on their own "proprietary modeling" petard. Models are only as good as historical information can make them--they cannot easily deal well with the rapid pace of financial innovations, and human judgment is especially important for new products.  But the ratings agencies tended to go in the other direction--worries about market share tended to support delays in revamping models to deal with financial innovations or to enable "massaging" numbers that would otherwise lead to lower ratings and declining market share.

Here are just a few of the important statements made at the hearing:

Raiter, 1995-2005 S&P head of residential mortgage rating group:

The rating agencies were granted preferred status by the SEC and then other regulators incorporated ratings into their investment and capital rules, but nobody provided regulatory oversight or standards to ensure the quality of ratings.

Senior management ...was focused on revenue, profit and ultimately share price. Management wanted increased revenues and profit while analysts wanted more staff, data and IT support which increased expenses and obviously reduced profit.

Michelek, structured derivative products group at Moody's 1999-2007, describes how a culture that started as somewhat staid, relaxed and intellectual transformed to a please-the-clients (investment bankers" culture with Sumo wrestling in fat suits at retreats under the new head, Brian Carlson.

Structured finance...raised the profile and magnified the importance of the rating agencies.  Almost by definition, structured finance products beget new structured finance products, with ever increasing degrees of complexity....

The incentives for the 'fee-based' structuring investment bank were clear; get the deal closed, and if there's a problem later on, it was just another case of "IBGYBG"-"I'll be gone, you'll be gone." ...

[The derivatives group in New York started out with a practice of using two analysts for each deal--a "quant" who would check the modeling and a lawyer who would review the documentation.  But as the decade wore on, this shifted.] This shift away from two analysts per deal was, in my opinion, reflective of both the desperately under-resourced status of the Group, and the predominance of the concern for cost control (despite internally reported profit margins that were nothing short of extraordinary).  ... (later comment on this issue at page 12) Nevertheless, it was hardly reassuring that soon after the initiation of rating CDOs in the London and Paris offices, complex structured finance transactions (including cash and synthetic CDOs) were being rated by only one analyst, referring all legal questions to a single (thinly stretched) lawyer based in London.

We did not 're-underwrite' any of the assets proposed for inclusion in the issuer's portfolio.  Errors in the ratings assigned to the underlying assets ... by definition compound into magnified errors in the derivative product. ... "Systematic" errors--where whole cohorts or classes of assets would be found to represent more risk than was identified by the original underwriting and the rating ...understandably created very significant problems for the rating of derivative products. ...

Goldman Sachs ..were the only bank I knew of that employed someone whose primary job was--to put it politely--arbitrage the rating agencies.  It was not difficult to know where Moody's stood in terms of the relative conservatism of our modeling assumptions and drafting requests; Goldman was very prompt when informing us that "S&P doesn't require that." ...

With every increase in issuance there was a concordant increase to the number and size of the structuring departments at banks.  And with every such increase, there was automatic need for increasing deal flow to service that new investment in staff. ...

To be effective, [any new legislation] will do well to recognize that meaningful ratings represent a public good, and as such some part of the function of a publicly 'approved' Credit Rating Agency should acknowledge and accept the responsibility--and liability--for providing that public good.

Cifuentes, Industrial Engineering, University of Chile and former Moody's Senior Vice President

[T]he ratings agencies exacerbated the magnitude of this [financial] crisis by making three significant negative contributions: 1) They misjudged the quality of these loans..., 2) They misjudged the risk associated [with] the securitization (re-packaging) of such loans..., and 3) They misjudged the risk associated [with] the re-securitizations, that is, re-packaging of debt issued by previous securitizations...  All in all, the combined effect of these three unfortunate actions was that a colossal number of securities perviously known as 'investment grade' which, until recently, was a synonym of 'low probability of defaulting.' have either defaulted or been downgraded. ...

One can only guess what could have happened if the rating agencies had monitored the subprime market with the same level of care that they seemed to have employed to monitor their market share.

Susan Barnes, currently a managing director at S&P's, provides a discussion of securitization that essentially claims that S&P has always done appropriate review based on the information provided by issuers. She provides a chronology of S&P's public statements about the deterioration of the securitization market and downgrades to RMBS deals.

Consistent with our commitment to transparency we repeatedly informed the market of our view that the credit quality of subprime loans was deteriorating and putting negative pressure on RMBS backed by those loans.  And, consistent with our commitment to analytical rigor, we revised our models, took action when we believed action was appropriate, and continue to look for ways to make our analytics as strong as they can be. ...

[T]he years 2005 and 2006 were characterized by an inreasing flow of publications and information from S&P...regarding the deterioration of the subprime mortgage market and the ahistorical performance of rated securities.  Beginning in late 2006, these observations resulted in the earliest and most severe rating actions that S&P has taken in this area.

McDaniel, chair and CEO of Moody's, and Yoshizawa, senior Managing Director, Moody's Investors Service, similarly claim to have highlighted the trend of escalating housing prices and loosening mortgage underwriting processes, though Moody's "like many others, did not anticipate the unprecedented confluence of forces that drove the unusually poor performance of subprime mortgages."

[P]otential conflicts exist regardless  of who pays [for ratings--investors or issuers].  The key is how well the rating agencies manage the potential conflicts.  We believe that Moody's manages the potential conflicts in our business model to a global best practice standard, and we have implemented a series of changes over the past year to further strengthen these standards. ...

Moody's comes into the residential mortgage securitization process well after a mortgage loan has been made...and has been identified to be sold and pooled into a residential mortgage-backed security by an originator and/or an investment bank.  We do not participate in the origination of the loan; we do not receive or review individual loan files; we do not conduct due diligence; we do not structure the security....  Rather we provide a public opinion (based on both qualitative and quantitative information) that speaks to one aspect of the securitization, specifically the credit risk associated with the securities that are issued by securitization structures. ...

*****

Beale here: What is perhaps most striking about these statements is the way the current rating agency personnel absolve themselves of responsibility by asserting that due diligence is not a part of their duties, and by avoiding discussion of the drive for market share and profits as a rating determinant.  Is it really possible for an analyst to do a decent job of forecasting ability of a securitization to make payments without actually looking at the underlying assets, rather than some spreadsheet of information drawn up by the issuer?  Can a rating agency determination that is provided to a customer to help that customer achieve the sales objectives it has set for the deal possibly be "independent" when the customer determines whether or not to use the rating agency and the fee paid is negotiated at the same time that discussions about the rating determination are ongoing?

Krugman concludes that the Subcommittee's "work on the financial crisis is increasingly looking like the 21st-century version of the Pecora hearings, which helped usher in New Deal-era financial regulation."  See Krugman, Berating the Raters, NY Times, Apr. 25, 2010.  But Krugman's key point is that the "deeply corrupt system" revealed by emails by rating agency employees is "a system that financial reform, as currently proposed, wouldn't fix."  Instead, "the ratings agencies skewed their assessments to please their clients [and that] helped the financial system take on far more risk than it could safely handle."

What possible refinements to the rating process for securitizations should be made--to the extent we think that securitizations are reasonable parts of the financial system of providing credit (an assumption that should itself be questioned in considering how to restructure the financial system)?   Krugman notes that the current bill before the Senate mainly makes it easier to sue for "knowing or reckless failure to do the right thing" whereas what is needed is "a fundamental change in the raters' incentives." 

What kinds of things might be considered?

• More transparency is needed--should all conversations and correspondence between issuer and rating agency be summarized as an exhibit that is part of the deal documents?  should rating agencies be required to provide a document summarizing the investigations they have conducted and their reasons for the rating provided as part of the deal documents?
• More analysis is needed--should every rating assignment require at least two analyst-participants whose final opinions must be included in the deal documents? 
• Less attention to market share is needed--should there be some kind of random assignment of rating agency reviewer to securitization deals, to remove the drive for market share from the equation (and if so, should there be a standard fee for ratings of complex structured products based on time spent by analysts rather than on type of deal)?
• More concern for the public interest is needed--should rating agencies be liable to investors when their "opinions" reflect a much more optimistic flavor than their internal documents and other analyses of relevant information show?   should their opinions be regulated like tax opinions by practitioners before the IRS under Circular 230--e.g., with specified requirements for disclosures and certifications of amount of certainty depending on the category of opinion (AAA requires a certification of more due diligence than BBB, etc.)?

Breaking News: SEC charges Goldman Sachs with fraud in mortgage deal

The SEC filed a suit today (Friday, Apr. 16, 2010) against Goldman Sachs and Fabrice Tourre (a Goldman Sachs vice president who helped create the investment in question).  See  Story & Morgenson, U.S. Accuses Goldman Sachs of Fraud in Mortgage Deal, NY Times (Apr. 16, 2010).  The suit accuses the huge investment bank of creating and selling a mortgage investment that it intended to fail, and betting against the investment.  This involves Abacus 2007-AC1, one of 25 deals created to permit Goldman to bet against the housing makret in the months after the potential for catastrophe was becoming apparent to banks facing losses on their hitherto enormously lucrative mortgage securitization product.

According to the complaint, Goldman created Abacus 2007-AC1 in February 2007, at the request of John A. Paulson, a prominent hedge fund manager who earned an estimated $3.7 billion in 2007 by correctly wagering that the housing bubble would burst.

Goldman let Mr. Paulson select mortgage bonds that he wanted to bet against — the ones he believed were most likely to lose value — and packaged those bonds into Abacus 2007-AC1, according to the S.E.C. complaint. Goldman then sold the Abacus deal to investors like foreign banks, pension funds, insurance companies and other hedge funds.

But the deck was stacked against the Abacus investors, the complaint contends, because the investment was filled with bonds chosen by Mr. Paulson as likely to default. Goldman told investors in Abacus marketing materials reviewed by The Times that the bonds would be chosen by an independent manager.

***

"Goldman wrongly permitted a client that was betting against the mortgage market to heavily influence which mortgage securities to include in an investment portfolio, while telling other investors that the securities were selected by an independent, objective third party." Id. (quoting Khuzami, director of SEC's division of enforcement).

Paulson, the hedge fund manager that wanted to short the housing bond market, was a good picker.  84% of the Abacus deal bonds, selected by Paulson as likely to default and good to go short against, were underwater within five months.  These deals were synthetic CDOs --i.e., deals with junkier tranches from earlier CDO deals with mortgage loans and credit default swaps finangled to get high ratings from the ratings services; but where the "investor" in the deal was essentially buying the original subprime bonds underlying the embedded CDOs.  Investors did not know they were investing in a group of bonds pre-selected for high likelihood of default. 

Michael Lewis's book, the Big Short, mentions these types of deals as well.  See, e.g.,the asterisked note on page 77, where Lewis notes:  "Goldman was in the position of selling bonds to its customers created by its own traders, so that they might bet against them." 

Goldman's stock has dropped 10% today, according to the Times.  Maybe holding Wall Street's TBTF banks accountable for fraud will be a way to downsize them, supplementing whatever financial reform package can actually make it through Congress?