Economics

We Are All Ignorant

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Over at Cato Policy Report, Jeffrey Friedman offers a sharp argument about the causes of the economic crisis. The article is notable for the stress it puts on the influence of ignorance—not as a problem to be solved, but as an unavoidable, universal aspect of the human condition. The essay is filled with examples; an excerpt should give you the idea:

The economics of time and ignorance.

[The Recourse Rule] created a huge artificial demand for mortgage-backed bonds, each of which required thousands of mortgages as collateral. Commercial banks duly met this demand by lowering their lending standards. When many of the same banks traded their mortgages for mortgage-backed bonds to gain "capital relief," they thought they were offloading the riskiest mortgages by buying only triple-A-rated slices of the resulting mortgage pools. The bankers appear to have been ignorant of yet another obscure regulation: a 1975 amendment to the SEC's Net Capital Rule, which turned the three existing rating companies—S&P, Moody's, and Fitch—into a legally protected oligopoly. The bankers' ignorance is suggested by e-mails unearthed during the recent trial of Ralph Cioffi and Matthew Tannin, who ran the two Bear Stearns hedge funds that invested heavily in highly rated subprime mortgage-backed bonds. The e-mails show that Tannin was a true believer in the soundness of those ratings; he and his partner were exonerated by the jury on the grounds that the two men were as surprised by the catastrophe as everyone else was. Like everyone else, they trusted S&P, Moody's, and Fitch. But as we would expect of corporations shielded from market competition, these three "rating agencies" had gotten sloppy. Moody's did not update its model of the residential mortgage market after 2002, when the boom was barely underway. And Moody's model, like those of its "competitors," determined how large they could make the AA and AAA slices of mortgage-backed securities.

The regulators seem to have been as ignorant of the implications of the relevant regulations as the bankers were. The SEC trusted the three rating agencies to continue their reliable performance even after its own 1975 ruling protected them from the market competition that had made their ratings reliable. Nearly everyone, from Alan Greenspan and Ben Bernanke on down, seemed to be ignorant of the various regulations that were pumping up house prices and pushing down lending standards. And the FDIC, the Fed, the Comptroller of the Currency, and the Office of Thrift Supervision, in promulgating one of those regulations, trusted the three rating companies when they decided that these companies' AA and AAA ratings would be the basis of the immense capital relief that the Recourse Rule conferred on investment-bank-issued mortgage-backed securities.

"Omniscience cannot be expected of human beings," Friedman concludes. "One really would have had to be a god to master the millions of pages in the Federal Register—not to mention the pages of the Register's state, local, and now international counterparts—so one could pick out the specific group of regulations, issued in different fields over the course of decades, that would end up conspiring to create the greatest banking crisis since the Great Depression. This storm may have been perfect, therefore, but it may not prove to be rare. New regulations are bound to interact unexpectedly with old ones if the regulators, being human, are ignorant of the old ones and of their effects."

NEXT: The Sweet Smell of Inflation, or, Never Trust Anybody Who Says "Nascent"

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  1. Over at Cato Policy Report, Jeffrey Friedman offers a sharp argument about the causes of the economic crisis that is notable for the stress it puts on the influence of ignorance[…]

    Phew!! And here I thought that the origin of the crisis was the explosive increase of easy credit and the misallocation of resources that followed it. Silly me!

    Nearly everyone, from Alan Greenspan and Ben Bernanke on down, seemed to be ignorant of the various regulations that were pumping up house prices and pushing down lending standards.

    I read the article several times, and the author misses the mark entirely: It wasn’t the ignorance of how the regulations were affecting the market that caused the problem, it was the regulations themselves!

    He’s not saying anything new about the ignorance of the regulators regarding the total effect the regulations were having on the market – Hayek already covered this with his description of the Knowledge Problem.

    1. Yes, he (and other Austrians who write in this vein) are building on Hayek. And the argument about ignorance is compatible with the ABCT argument about credit and malinvestment.

    2. I read the article several times, and the author misses the mark entirely: It wasn’t the ignorance of how the regulations were affecting the market that caused the problem, it was the regulations themselves!

      Six of one, one half baker’s dozen of the other.

      1. speaking of which, I haven’t recieved a baker’s dozen of anything in a long time.

  2. I was in the military service at one time. The rules are written such that it is impossible to comply with those which are mutually contradictory. No matter what you did, you were subject to punishment.
    Similarly, Shermer points out the result of anti-trust laws:
    If you charge too much, you’re guilty of ‘gouging’.
    Charge too little and it’s ‘undercutting the competition’.
    Charge the same, it’s ‘collusion’.
    Don’t have competition? ‘Monopoly’.

  3. I call Bullshit. I did time in one of the top 5 law firms in the county which had a huge capital markets department. Any 1st year legal associate working in a capital markets department whose ever done a registration statement of a rated bond offering (or exchange offer) would see the requirement that a rating meant one from Fitch, Moody’s or S&P. Furthermore, the legal requirement was also an industry standard – every standard Commercial Loan Agreement, Note Agreement and other debt agreement that was subject to registration, if it required a rating, ALWAYS states that a rating means a rating by Fitch, Moody’s and S&P. So the statement “The bankers appear to have been ignorant of yet another obscure regulation: a 1975 amendment to the SEC’s Net Capital Rule, which turned the three existing rating companies — S&P, Moody’s, and Fitch — into a legally protected oligopoly” is possibly the stupidest thing I’ve ever read. The legal and practical special status of S&P, Moody’s and Fitch was no great esoteric secret, it common knowledge and common practice. The requirement was accepted because everyone assumed that the perfunctory step of getting the rating wasn’t the real guarantee of the securities quality – it was the backing of the underwriter and their research. No. People were making tons of money and investors were starved for yield by the incredibly low interest rates. Those who knew better had no choice (or at least felt they had none) but to dance while the music was playing because failure to do so would be failure to make their “book” by the end of the year and get their clocked cleaned by those who were willing to play the game.

  4. Correction – the statement “every standard Commercial Loan Agreement, Note Agreement and other debt agreement that was subject to registration” should have said “that was not subject to registration”. That is, even a commercial loan that wasn’t subject to registration requirements still limited an acceptable rating to one from those three agencies only.

    1. Well, hold on. That can’t be right. You’re suggesting the privately owned ratings agencies were too lightly regulated and in fact gave self-interested, distorted ratings as a matter of course for all bond issues and that the Street knew this and said nothing about the market-distorting effects.

      And we know that’s not possible because regulation is always bad and unregulated markets are always the best way to do things. I know, because I read it in Reason.

      Oh, and Drew Carey told me.

      1. No. I’m suggesting that EVERYONE knew that the privately owned rating agencies were indeed in possession of a privileged status THANKS to government regulation. Because of that, everyone discounted the value of the ratings that they spewed forth and treated it as a necessary (but perfunctory) step.

        1. Amen.

          1. Well, sort of. At least you agree on the outcome: that the firms consuming the ratings knew full well that they were a load of manure.

            Again, it leaves the classic libertarian-liberal split: that liberals believe that honest regulation would prevent the ratings from being manure, and libertarians believe that consumers of ratings would seek honest ratings in a regulation-free market.

            Me, I acknowledge that when government is broken and pervasively corrupt, it’s tough to have honest regulation, but I also question the ideas that the companies that took advantage of horseshit ratings would have for some reason wanted to use honest ratings to market their products, or that “the market” of the same ignorant rubes Friedman purports it to be, would have the expert knowledge necessary to distinguish between honest ratings and horseshit ratings.

            Me, I think horseshit ratings were simply the marketing tool of choice for a toxic product that would have been marketed through whatever means necessary in their absence. The housing bubbles of the 1920s were not the product of a compromised market for asset ratings. Then as now, blanket advertising, free toasters and pony rides for the business press worked just fine.

      2. What I am calling bullshit to is the idea that somehow none of these people where aware of this special regulatory granted privileged monopoly status. My example regarding private note and credit agreements requiring ratings from the same 3 institutions was made to point out that, in practice, even agreements that were not governed by registration requirements routinely accept as a standard the REGULATED norm.

        I don’t know what statement you read, but it wasn’t mine

        1. So was there regulation preventing the ratings agencies from holding the securities they were rating?

          If no, then that seems like a clear cut case of underregulation.

          And if yes, then that’s a case of the industry all knowing the agencies were full of shit and playing along anyway…and blaming the laws they weren’t following for the systemic risk that resulted.

          1. Oral Hazard: Do not imbibe any substance that comes out of Orel Hazard’s mouth. Do not place anything of value inside Orel Hazard’s mouth.

      3. Uh, try reading the article; stupid strawmen are stupid strawmen. Usually from stupid people.

        1. Boy, the threaded comments are *fun*!
          My comment was directed at Orel Hazard.
          Suki, don’t know what you mean.

        2. I love how nobody can answer why the ratings agencies were allowed to hold the securities they rated.

          I also love how apologists for free-market fundamentalism believe in magic. They pretend that regulation mandating the (widely ignored, perfunctory) rating of a bond at the time of its issue magically blames the SEC for the systemic problem of distorted ratings.

          Ratings were distorted because the privately held agencies profited by doing so: they were all unregulated enough to be allowed to hold the securities they rated and be paid by the issuers.

          http://bit.ly/9pLaD1

          Gee. You’d think this crowd could recognize enlightened self-interest, quid pro quo and an unregulated market in securities ratings when they saw it. Guess not. I guess it’s easier to repeat the myth of the jackboot of Big Gubmint stomping all over the poor market.

          1. But It is the Gubmint fault.

          2. Hey retard: “The SEC trusted the three rating agencies to continue their reliable performance even after its own 1975 ruling protected them from the market competition that had made their ratings reliable.”

            If they have no competition of course they are going to be able to sell whatever crappy service they come up with. Sorry, can’t blame this on a free market that doesn’t exist.

          3. “Gee. You’d think this crowd could recognize enlightened self-interest, quid pro quo and an unregulated market in securities ratings when they saw it.”

            Unregulated??? See the above article. Try reading next time.

            1. You’re not understanding the difference between regulation of bond issuers and regulation of bond rating agencies.

              Bond issuers are mandated by the SEC to go obtain a rating from the rating agencies. The point of the article is to say that bond issuers were “unaware” that ratings agencies were providing bullshit ratings. An attorney higher in the thread challenged this.

              But the article calls the ratings agencies’ work “sloppy” and a result of “ogilopoly” when non-libertarians and other adults know very well that the work wasn’t sloppy at all: it was distorted on purpose due to their conflicts of interest. This was because the agencies were NOT regulated ENOUGH to prevent their holding the securities they rated, inflating their value and minting money for themselves in doing it.

              Let me know if there’s anything else you need explained.

              1. it was distorted on purpose due to their conflicts of interest

                [citation needed]

                Never attribute to malice what you can attribute to stupidity.

              2. You’re playing the same game illustrated in the article: The ratings agencies that became trustworthy due to free-ish market pressures got blessed with a regulatory monopoly. Now that they aren’t trustworthy anymore due to misguided regulation, you want to tweak the regulation to “make” them trustworthy again.

                You don’t seem to even consider the possibility that the regulation that protected them from competition was at the root of this aspect of the problem.

              3. it was not distorted on purpose. They got lazy.

                The problem was that the housing market started exhibiting natioally correlated behavior due to the boom. But the risk models assume that all local housing markets are uncorrelated.

                This is what allows you to reduce risk by selling a basket of mortgages from all over the countery. Even if one local market goes bust, others will still be doing fine. You get lower returns, but you also reduce your exposure to market fluctuations.

                But if all the markets start exhibiting correlations, that means the risk of all or most of them going bust simultaneously (which is what happened) is much greater.

                Hence, IF they had updated their mdoel to account for the correlations in the housing market, their ratings would have been much lower.

                But they did not update it after 2002. They were flying blind. I.e. they got lazy, and that laziness has a great deal to do with the fact that they are a government-granted oligoloply protected from competition.

                1. Astonishing.

                  I can find article after article demonstrating one after another instance of Fitch and Moody’s being paid hundreds of thousands in consulting fees by packagers / issuers who were never covered by the Net Capital Rule at the time of issue – and who then kept the ratings artificially high for long enough for the hot potato dogshit bonds or CDSs to be sold to Iceland and points beyond. This makes no impression on you.

                  But the fact that the SEC requires a rating for some bonds at issue time, and named three vendors to do that – to you, that means they were blameless angels lulled off their best work by being guaranteed a number of customers by law. Somehow the other 50% of their business (at least 50, it’s probably higher), their unregulated holdings and the unregulated holdings of their execs, aka their plain conflict of interest – all of that is just hunky-dory and had no role in the explosion.

                  Let me guess: when a plane crashes, you blame the ground. No, wait, you blame the FAA.

    2. Tell that to Ron L. He was in the military and it was different there.

    3. Everyone is ignorant about lots of things. That’s the point of the article. The question is whether enough voters have had their ignorance about Obama’s truthiness and the Democratic majority’s ignorance of basic economic principles to elect some adult supervision, or failing that, at least divided government so two different brands of economic foolishness will deadlock and prevent each other from doing much damage.

      / really cynical thinking

      1. should read “have had their ignorance DISPELLED about Obama’s …”

    4. It is my understanding that some (?all?) bonds must be rated by these agencies to meet certain accounting standards and various bank and financial institution soundness regulations. True?
      Also I have read that municipal bonds were rated as equal in risk to private bonds that had as much as a 10 fold greater risk of default. Any thoughts on that? If it were true, it strikes me that perhaps bond buyers are…uh…developmentally disabled. I cannot figure out why anybody would buy a treasury at the interest rates being paid, unless required under those soundness regulations.

  5. It became obvious in November of 2008 that roughly 99% of registered voters were ignorant. I hope this is changing. I think it is. We may find out this November.

  6. but as an unavoidable, universal aspect of the human condition

    Anyone with a brain who has been in the workforce for even a little while knows this, or should. Ignorance–and its sibling, incompetence–are rampant. And when you make a situation worse, by having too many layers of management, or too much bureaucracy, or too much regulation, it increases exponentially.

    Everyone knows that bureaucracy is inefficient; even huge statists will nod knowingly if someone recounts a tale of a horrible afternoon at the DMV. And then they’ll turn around and promote regulations, which are of course enforced by…a bureaucracy. Geniuses, they are.

    1. In Florida I have spent as much as six hours at the DMV, but in Oregon where we pay higher taxes and have enough people to do the job I have never spent longer that twenty minutes.

      1. Just because dead people and terrorists can drive and vote there doesn’t make it more efficient.

      2. Wow, way to miss the point. Entirely.

    2. Geniuses, they are.

      Said with a Yoda voice, with a thinly disguised veneer of sarcasm.

      1. A Jedi genius you will be!

  7. Wow, Orel Hazard got shredded in short order.
    OH, that might be your new record for complete dismantling in a thread. And it didn’t even need to happen. Your knee jerk response just couldn’t keep to itself, and you exposed your inability to read what is directly in your face.

        1. you’re a pig.

    1. Well, anyone who picks a screen name that implies they use teeth while giving blowjobs deserves to get shredded.

      /complete lack of propriety or couth

      1. complete lack of propriety or couth glass house nominees

        prolefeed|12.4.09 @ 2:40PM|#
        …And then there’s always this for an alternative (a rare safe for work prolefeed link!)

        prolefeed|12.4.09 @ 4:04PM|#
        Insert lewd joke about Warty’s “Harris Teeters” HIER …

        prolefeed|11.16.09 @ 3:31PM|#
        So “threading toggle” is the new slang for 69ing?

        prolefeed|11.16.09 @ 5:24PM|#
        If you can figure out how to do fucking blockquote tags.

        prolefeed|2.6.08 @ 3:00PM|#
        Vinyl burqas? I imagine there is porn of this.
        Warty — plenty of vinyl porn, no burqa porn at all. A niche marketing opportunity?

        1. Hey libertarian bitch patrol

          **cough** blowjob **cough** blowjob **cough**

          1. Is that from the book of Mormon?

            1. No, it was an offer from your mother.

              Damn, too easy.

              1. anatomically Impossible

                1. I didn’t say it occurred any time recently. LBP, I’m afraid though it pains me greatly, I have something to tell you.

                    1. alan, don’t confuse me with your mother.

                    2. Come on RCTL – not so mean.

  8. Those who knew better had no choice (or at least felt they had none) but to dance while the music was playing because failure to do so would be failure to make their “book” by the end of the year and get their clocked cleaned by those who were willing to play the game.

    I don’t know whether to give +10 or -10 for the Most Mixed Metaphor of the year.

    The legal and practical special status of S&P, Moody’s and Fitch was no great esoteric secret, it common knowledge and common practice.

    Yes, but as you admit in the very next sentence, people were ignorant about what that meant:

    The requirement was accepted because everyone assumed that the perfunctory step of getting the rating wasn’t the real guarantee of the securities quality

    Well, for one, the e-mail traffic the author seems to undercut your point and states that the metrics buyers were using when it came to purchasing decisions did, some times, come from the bond ratings themselves.

    The larger point is that people don’t understand the ramifications of a legally-granted monopoly, which is that the product will, eventually, suck because, why wouldn’t it? Monopolies enshrined by the government have no incentive to be good or even honest.

    So was there regulation preventing the ratings agencies from holding the securities they were rating?

    Ha, Blake’s right – you don’t even know what we’re talking about at this point.

  9. OMG, Epi…there’s a three-bag limit on trolls in these parts.

    1. I never obey bag limits. Besides, how is the ranger going to catch me?

  10. GOOD MORNING reason!

    1. GO AWAY Suki!

      1. Suki is the “Butters” of Hit and Run

  11. “We are All Ignorant”

    Hmmm. I didn’t know that.

  12. liberals — society and markets have grown too complex to function without a large, complex government regulating it in great detail

    Friedman (and Hayek) — society and markets have ALWAYS been too complex to function well with a large, complex government regulating it in great detail, and with added complexity, the urgency to pare back government involvement grows even more — the more complex and large, the more you have to trust in distributed, informal networks to handle all this information

    1. This isn’t the nineteenth century, PEOPLE!

  13. NOM NOM NOM I ENJOY COCK

  14. PENETRATE MY ANUS AND MY MOUTH

  15. I MUST QUENCH MY THIRST WITH MAN JUICE

  16. Little bitches can’t argue the facts. Wow, you are really giving it to OH.

    1. Little bitches can’t argue the facts.

      I see quite a bit of arguing over the facts in this thread (though not on your part). But the basic debate with OH rests on the interpretation of the facts, not the facts themselves. OH thinks corruption proves the need for more regulations. Libertarians argue that the same regulatory shield from competition that makes it easier to be sloppy without consequences also makes it easier to be corrupt without consequences. You’ll find similar debates about pretty much any industry where regulatory capture has taken place.

      1. This is the overall theme of the article: Misguided regulation, taking free market benefits for granted, eliminates free market benefits causing market failures leading to calls for…more regulation.

        The assumption from the pro-regulation crowd is that you can engineer a better market than the free market, if you can just keep tweaking the rules of the game. What they fail to notice is how the problems they are addressing were all introduced by the last set of new rules.

        1. The Net Capital Rule is NOT the rule that causes Fitch to take millions in consulting fees for bundling and packaging, nor does it have anything to do with Fitch owning the securities whose ratings they keep artificially high. That rule is not a SEC reg. It is called the We Gotta Get Ours At Any Cost rule.

          Agencies’ conflict of interest grows most significantly LONG AFTER any ratings given at issue time under the Net Capital Rule – and then there’s the huge chunk of business that doesn’t even fall under that rule.

          This myth that rules ruin markets but conflict of interest doesn’t is so incredibly full of shit, it’s a wonder the text on the screen isn’t brown.

  17. Having read all this, I feel a little dirty now.

  18. Pardon me while I whore my blog:

    The Cause of the 2008 Mortgage Crash

  19. I thought markets knew everything, that they were, you know, efficient. Now libertarians are telling us that no one knows anything.

    I think Alan Greenspan was a tad more honest when he said that he used to believe that markets were inherently self-policing, but now he believes that he was, well, wrong.

    1. THANK YOU

  20. Puh-leeze. The oligopoly of ratings agencies and the patchwork of gutted regulations didn’t contribute to the crisis because they reduced the quantity and quality of information available.

    They contributed to the crisis by offering a way for the snake-oil salesmen running the banks and investment firms to hide behind plausible deniability. The changes to the regulatory framework in the decades following Reagan’s election were deliberate.

    Certainly there was ignorance: there was the ignorance of many homebuyers, there was the ignorance of many knucklehead real estate salespeople and mortgage brokers, but go one step up the food chain and, I’m sorry, but the bubble was as plain as day. Real estate appraisers were complaining all along about how the way they got paid subjected them to pressure from mortgage and real estate companies to goose their estimates. Anyone who spent any amount of time looking at the sales histories of the properties they were dealing in knew what, yes, the California and Florida coastal paradises could and did experience overbuilding, substantial price drops and long periods of stagnation. Many of the South Florida star brokers and developers who insist that, golly, they were blindsided by this crash had experienced the very clear, measurable link between marketing-driven speculative overbuilding and an ensuing crash just fifteen years before, in the early 1990s. I vividly recall, when I was a newly-licensed agent in Fort Lauderdale in 2003, frequent, open conversations among agents about the bubble being inflated, the idiocy of building multiple luxury condo skyscrapers in downtown Fort Lauderdale, a mile and a half from the abundant inventory and ample underutilized land right on the beach and the Intracoastal, about how some two thirds of buyers were investors looking to flip, about how when the buildings were completed they would be empty and every unit would be put up for sale by someone hoping to make a quick buck.

    By 2005, the more self-aware mortgage brokers openly spoke of the way large commissions and sales incentives encouraged them to pitch Option ARMs and interest-only products to everyone and about the instructions from above to play fast and loose with loan applications.

    I can hardly see how a fully-deregulated Barbie Dream Market would have magically helped any of this when the people who know what ratings even are were only using the ratings as a cover to shift blame when the music stopped.

    I suppose a left-anarchist could make the argument that total deregulation would prevent this situation by breaking down hierarchies of all kinds and the ability to form large webs of trust so thoroughly as to make it impossible for a bank to function beyond a 3-mile radius. There is that. But in the context of the world we have and not the post-revolutionary moonscape of an anarchist’s dreams, advocating deregulation simply helps the.. well.. oligarchs.. who fund “libertarian” Cato and Reason and their “right wing” peers alike.

    1. Thank you for so clearly illustrating the evils of preemption created by regulation. After all, why try to do things better when the government has legally defined a floor that is considered “good enough”?

  21. Anyone who spent any amount of time looking at the sales histories of the properties they were dealing in knew what, yes, the California and Florida coastal paradises could and did experience overbuilding, substantial price drops and long periods of stagnation.

    Friedman’s argument does not involve people who spent their time looking at the sales histories of the properties. It involves outsiders who were using the agencies’ ratings as a proxy for such local knowledge.

    1. Friedman’s argument involves buying the idea that the entire leadership and research staffs of Citigroup, BoA, Washington Mutual, Wachovia, Wells Fargo, Lehman, Bear, HSBC, CSFB, all the Federal Reserve banks, the Treasury Department, the Commerce Department, the state banking and real estate regulatory agencies, the NAHB, the Mortgage Bankers’ Association, the property assessors’ offices of thousands of cities and counties, the owners of property appraisal companies big and small, business “journalists”, and everyone else in these sectors who bothered to look at the market analyses–complete with tax assessment history printouts–prepared by the Realtor they bought or sold their house through were all using the ratings agencies as a proxy for the paperwork that passed through their hands every day, that none had any recollection of any of the admittedly smaller asset bubbles and crashes that had occurred around them in their lifetimes, and none wondered what the aggregate effect might be on loan portfolios if the inflated income figure they were instructed to write on their loan application was typical of even a fraction of the loans being made.

      Friedman’s piece is either projection of a staggering level of ignorance of his own on all of the above, or it’s deliberate cover for the companies and officials who knew better and got rich off it. Either way, Cato’s funders are getting what they pay for and no doubt pleased.

      1. Friedman’s argument involves buying the idea that the entire leadership and research staffs…blah blah blah

        Stop. No it does not require that at all. Like I said upthread, never attribute to malice what you can contribute to stupidity (or ignorance). The implication of your thesis is that all of those agencies colluded…which is totally ridiculous.

        1. Collusion doesn’t have to be a bunch of guys with cigars sitting in the back room of an Italian restaurant plotting together. It can just be a lot of people who know perfectly well what’s going on and keeping their mouths shut because it’s working out well for them and the people around them, and, well… fully loaded Escalade! Awesome!

          1. Friedman’s argument about ignorance is not incompatible with an argument about corruption. Indeed, if the malice and ignorance are each concentrated in the appropriate places, they’ll be mutually reinforcing.

            1. I agree with that, though I don’t buy the idea that the ignorance was nearly that pervasive at all, and I still think Friedman’s arguments are more self- (or client-) serving than honest.

            2. Jesse,

              Don’t know why you seem to be wedded to this argument, but I can tell you from direct and personal experience that most lawyers, bankers and SEC personnel that I dealt with during my 7/8 years of capital markets work (in late 90s early 00s) were either indifferent or contemptuous of the ratings agencies (bankers would often say that they were peopled by analysts too stupid to work at an iBank). The way they built their ratings was fully comprehended by the bankers – they preemptively did balance sheet repair and structured securities and guarantees so they could check all the right boxes. As I said above, ratings were largely perfunctory – I never saw a single instance where a rating sought was denied.

              Does this mean that the answer should have been more regulation? No. The very presence of the rating agencies lulled purchasers of securities (for the most part institutional investors) to sleep by assuming that the securities were blessed. But to argue that all those players were somehow ignorant of the process of the ratings agencies (you would have to be to claim blindly that you trusted a security merely for the ratings) is a load of steaming …

              1. Want to be clear that the institutional purchasers were not really relying on the ratings agency blessing – but were relying on the fact that the rating made the security marketable and liquid because it fulfilled internal requirements of those institutions (such as pension funds whose internal rules required ratings of a minimum level). So the rating was like a “good housekeeping” seal of approval: it gave the MD working in an institutional investor an internal pass from having to really justify the quality of the security.

                1. You seem to think the choice is between having no ratings agencies and having bad ratings agencies.

                  I think that’s nuts. We’ve never tried making conflict of interest at an agency illegal, for one thing. Put some of these little shits in handcuffs when they’re found to hold the stuff they’re rating and then watch some “enlightened self interest” do its stuff.

      2. You make a valid point that Friedman might be overselling the role of ignorance, but you are buying into an all-or-nothing fallacy.

        While certainly many saw the naked emperor and went along because their skins weren’t on the line, and many many more suspected, the overwhelming majority of those who did stand to lose were ignorant of the perverse incentives driving the lies they were getting from the ratings agencies. Included in that majority were regulators whose job it is to spot these kinds of problems. They are professional paid skeptics who didn’t stand to gain from the shenanigans, yet they did and said nothing until after the fan was besmirched.

    2. Oh, and Friedman’s argument also involves believing that fund managers, investment managers and their entire research staffs across the board relied on nothing but agency ratings and technical charts to make all of their decisions from 2001 onward, and that none whatsoever looked at industry or economic data of any kind as part of their work.

  22. I thought markets knew everything, that they were, you know, efficient. Now libertarians are telling us that no one knows anything.

    massive comprehension fail. I’ll restate the premise for the slow (i.e. you): “the impossibility of knowing everything in the 100,000 page federal register contributed to the collapse because bankers were making decisions on ignorance of those regulations”.

    Clamp a hand down on that knee, there, sparky.

    I vividly recall, when I was a newly-licensed agent in Fort Lauderdale in 2003

    Oh, a pompous, know-it-all real-estate agent. Is there any private trade more loathsome?

  23. What caused the financial crisis?

    The crisis was an inevitable result of the boom.

    What the regulatory structure, any so-called deregulatory changes, and related policies did was determined how the bust manifested.

    When the bust occurred was determined by unexpected destabilizing events in weaker areas of the boom. Possibly when a spike in gas prices made long distance commutes unfeasible causing a drop in demand for housing far from employment centers.

    Value is a psychological phenomenon and so financial instruments that were perceived as valuable quite quickly became perceived as worthless.

    Let us thank the government for making it so difficult for so many people to acquire the financial buffer of savings and leaving them living close the the financial edge, indeed, for most of us, closer to the edge than we would otherwise choose.

  24. I was interrupted.

    So, in conclusion, the real question to answer is not “what caused the bust”, but rather, “what caused the boom”.

    1. That’s a really good point. One thing that I have seen is that purchases of Treasuries was so robust from 2002 to, well, a week ago, that investors wanted/needed an alternate risk free instrument that provided a real yield greater than zero. The MBSs, the great majority of which had an underlying guarantee by the GSEs, fit the bill as most investors implicitly understood that, if those securities were ever in danger of default, the GOVERNMENT would backstop them (good guess, since this is exactly what has happened). So the MBSs that got us into this mess where highly marketable because they were seen a risk free investment alternative to Treasuries, but at a higher yield.

      What could go wrong?

      1. “purchase of Treasuries FROM CHINA which held down the interest rate”

        fixed

  25. A key factor being left out of this discussion is that the rating on the bonds often set the prices on derivatives, like credit default swaps and collateralized debt obligations.

    A low-risk investment is cheaper to insure than a high risk one. Why do you think AIG ended up so deep in the hole?

    Maybe the guys selling MBS at some level knew the ratings were shit. But two steps down the chain the guy trading various options and derivative that are based on those ratings probably doesn’t.

  26. This American Life broadcasted an excellent show on the role of bond ratings and how it affected the collapse of MBS’s.

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