An Expert-Induced Bubble

The nasty role of ratings agencies in the busted housing market

How is it that assets built out of mortgages which just yesterday were worth so much are worth so little today? Investors have only recently come to realize that the ratings for these assets were terribly biased. The question now is why we ever came to believe mortgage-backed securities were worth our investing dollars in the first place. There is of course much blame to go around. But insufficient attention has been paid to how ordinary investors—not greedy capitalists but instead those of us who are trying to save for our retirement, our kids' college education, or, indeed, the down payment for a house!—trusted the experts and got burned.

Experts are constantly telling investors what to buy. Sometimes they give us good advice and sometimes not. So surely the fact that there are experts who give investment advice can't explain the trillion-dollar bubble and subsequent meltdown we're now witnessing. The key additional fact is that experts were selling advice about mortgage-backed assets as if those assets were independent when, in reality, they weren't at all independent assets. Only once investors realized that the housing market is a national market—not a local one—did it become clear that these securities were extraordinarily risky. Hence the collapse.

Until very recently it was widely believed that all housing markets were local. If this were so, then assets constructed by pooling mortgages across different localities would consist of pooled independent assets. And these new assets would be dramatically less risky to hold than a single mortgage of similar worth: Combine a bunch of diverse mortgages and sell shares of the new security and those shares represent much less risk than holding a single mortgage of the same value as the share. Or so the story went.

All of this, however, depended critically on housing markets being local, so that the assets in the pooled security didn't move together. Not so long ago, this was the conventional wisdom. Federal Reserve Chairman Alan Greenspan testified to this effect before Congress in 2005, when the housing bubble was well under way: "The housing market in the United States is quite heterogeneous, and it does not have the capacity to move excesses easily from one area to another. Instead, we have a collection of only loosely connected local markets."

So, following Greenspan's advice, a firm could build highly rated investment portfolios of purportedly uncorrelated assets out of nothing but mortgages from different parts of the country. Once these portfolios were built, it would become easier to finance houses even for buyers of dubious credit.  The problem was that these new securities, and the money which flowed into all housing markets, were sufficient to generate correlation in housing values across the country. As everyone followed the experts' advice—and invested in these new mortgage-backed assets—we began to observe correlated behavior in the housing market, nationwide. 

So how did the securities maintain their high investment grades? Once correlations were evident, once the interconnectedness of housing markets nationwide was evident, why didn't another set of experts, the rating agencies, step in and downgrade the securities? 

Because of incentives, the cornerstone of economists' advice about how to get good economic outcomes. In this case, the incentives weren't there to obtaining unbiased estimates of security values. Instead, incentives favored "rating shopping" and so, unsurprisingly, rating shopping became the norm. The Securities and Exchange Commission's 1994 reportConcept Release: The Nationally Recognized Statistical Ratings Organization (NRSRO), contained the following sentences:"A mortgage related security must, among other things, be rated in one of the two highest rating categories by at least one NRSRO." The phrase "one of the two highest rating categories" authorized the firm holding a mortgage backed security to shop for ratings. If one rating agency failed to produce a desirable rating, the firm could look for another, more favorable rating.

Those who made the ratings became like expert witnesses in court, seeing things the way their clients, the firms holding the securities and offering them for sale to you and me, wanted things to be seen. The problem was that shoppers, like a jury, did not have the ability to average out different pieces of testimony to help remove the bias.  As long as experts were trusted and the market didn't know the difference between unbiased and biased estimates, the trick worked marvelously.  The collapse followed suddenly as we have all come to understand that the ratings were miserably biased.

All of this is a telling lesson about how much and when to trust the experts. This is especially so now that a new set of experts is attempting to get us all out of the mess we're in.

David M. Levy is an economist at George Mason University and Sandra J. Peart is an economist at University of Richmond. They are the authors of The Vanity of the Philosopher: From Equality to Hierarchy in Post-Classical Economics.

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  • ed||

    There is of course much blame to go around....

    Let's not forget to include the mainstream media, who continue to stupidly parrot politicians by neatly focusing the situation into a "Wall Street-Main Street" rivalry, with Wall Street portrayed by Snidely Whiplash and Main Street as poor, defenseless Nell.

  • ||

    Nonsense. I have it on good authority that the entire financial crisis is the direct and deliberate work of Barack Obama, who, with his cronies at ACORN and Freddie/Fannie, has been working for years to destroy capitalism and instate sharia law to turn us all into communist Muslims. That is the sole reason for our current situation and the only possible solution is to defeat the ubervillain Obama by electing Palin/McCain.

  • JMR||

    No, no, it's all the fault of Ron Paul & his evil advisors!!!

  • johnl||

    OK article. But I don't think a lot of rating shopping went on. S&P packaged their rating formula as software as well as a document, as did some other small shops (DBRS). There were objective criteria as to how something would be rated. The problem was that the criteria were wrong.

    Part of the problem is that as the housing market was climbing from ?1994? till 2004, basically nobody defaulted on heir mortgage. So if you said you thought that those loans would have losses of something like 150 bp, people would laugh at you. Also nobody had any computerized records of what happened in the 80's or early 90's, so there was no data to build individual outcome models.

  • ||

    Good Article. Add this to the fact that most mortgage lenders and banks outsourced their credit risk management obligations to government created monopolies while buying investments guaranteed by these same entities. All of this concentrates risk and is a formula for disaster.

  • Contextant||

    Sounds like rating agencies are a lot like real estate appraisers. There are some standards, but there is also wriggle room for judgment. The appraiser merely needs his valuations to be "supportable" by comparable properties - so he can't stretch more than about 10% over or under - which is still quite a bit. Any more than this and he will be open to charges of fraud.
    Sounds like these raters might have as much or more discretion, and if they are overrating securities, it would take a long time for anyone to find out. It's not like it's as obvious as a broken down house.

  • ||

    To add to David's comment, above, the investors who purchased these securities also outsourced their credit analysis obligation to the rating agencies. People bought the securities just based on the rating. By gutting their credit staffs (overhead!), originators and investors failed to realize that the cost of information was an important underpinning of the investment decsion. While there is great benefit in diversification of risk, investors can't rely on that alone and it adds additional risk when the underlying ratings are on a weak foundation. To a large extent, the business was excessively operationalized to the extent that meaning was lost in the process.

  • Snickers||

    It's really fun watching people try to blame this mess on anything other than casino "capitalism". This form of gambling has not, does not, and will not ever work. Time to run it out of town.

    See "'This time is different': eight hundred years of financial folly" by
    Carmen Reinhart at Vox.

    http://www.voxeu.org/index.php?q=node/1466

    See also Nassim Nicholas Taleb: "They [Wall Street financial institutions] have proven a total inability to make money on risk-taking, and we, I wrote about it in 'The Black Swan,' they failed in 1983, '82, '83 with the international debt crisis. They lost everything they made then in the history of banking. They did it again in '91, that real estate crisis, that resembles to a 'T' the current subprime one, and they lost again now. So we have the convincing argument to ban these institutions from taking risks."

    http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aD5GOcOLTnNw

    Let's face it folks. This shit is not capitalism it is gambling, and it's time to not to nationalize but to close the casino.

    We're either going to wind it down ourselves or have our asses handed to us by the rest of the world.

  • Don the libertarian Democrat||

    Can someone tell me how to regulate bias?

  • Scott||

    I could pin the blame on Santa Clause if I used circumstantial evidence as loosely as the authors.

    To accuse people of being intellectually dishonest requires more than a motive. It would be nice, for example, to cite facts.

  • Owen McShane||

    While the securities market might have been homogenous US housing markets are certainly not.
    The California markets, severely infected with the virus of Smart Growth had hugely inflated house prices and are now suffering massive falls in value and consequent massive losses per foreclosure.
    Compare this with the lightly regulated land markets in Texas and Houston in particular where housing is still affordable and foreclosures are fewer and losses per foreclosure and much smaller.
    See Demographia for the different levels of inflation in house prices round the world and the direct correlation between Smart GRowth and other forms of dense thinking and the diameter of the bubble.

  • ||

    Two comments about the rating agencies. First, not only did they get payed for the rating, the packager got advise from the rating firms- a clear conflict of interest. When a pool of mortgages was too week to get a triple A rating, the raters told the packagers how much money they would have to back the pool with (called topping off) in order to get the AAA. Second, the raters had nothing to lose; they have a government-mandated protection; they can't be sued for giving a false rating. Unless, possibly, if they were involved in a criminal conspiracy with the packagers. I can't wait for the state AGs to figure that one out.

  • ||

    Hasty and sloppily written. C-

    Critical part:

    "In this case, the incentives weren't there to obtaining unbiased estimates of
    security values. Instead, incentives favored "rating shopping" and so, unsurprisingly, rating shopping
    became the norm."

    Who obtained estimates? Rate shopping among how many agencies? How do the agencies themselves operate, and under whose oversight, if not the market?

    This quality of this article is like the federal government's implicit guarantee to Freddie and Fannie: write as poorly as you wish, you'll always have a job at Reason.

  • ||

    I think the other important point regarding the correlation of risk is that the credit (default) risk of the subprime loans that make up a CDO pool would seem to have a very high correlation. The belief (supported by the ratings agencies) that these securities diversified risk (when in fact they may have compounded it) was based on the false premise that defaults are random, uncorrelated events. I would argue that the macroeconomic and behavioural factors that lead to default, particularly at the subprime level, are common across geographies and homeowners.

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