Saturday, June 05, 2010

Break the Bloody Glass

Case Study #1

From the EU Observer, June 3, 2010:

Brussels Sets Out Plans to Regulate Credit Rating Agencies

BRUSSELS — The European Commission has come forward with a list of amendments to revise EU rules on credit rating agencies, aiming to boost transparency and centralise supervision at the European level.

Under the proposals, the European Securities and Markets Authority (ESMA) — a new body whose legislation is currently being negotiated by member states and the European Parliament — will take over the supervision of rating agencies in Europe from national authorities.

Case Study #2

From today’s Multicultural Newsline:

BarometerGENEVA —Early last month he United Nations Council for Law and the Environment (UNCLE) released a report that confirms what many people have long suspected: the effects of barometric pressure are not distributed equally among various ethnic groups, especially in Europe and North America. UNCLE’s research reveals that extreme barometric conditions — both hyperbaric (high pressure) and hypobaric (low pressure) — are more likely to have adverse effects on non-whites than whites, and are also more deleterious to women, the disabled, gays, lesbians, bisexuals, and the trangendered.

This phenomenon has long been known to climate ethnologists, who call it DICE — the “Disparate Impact of Climate on Ethnicities”. Minority groups are 27% more likely to suffer from illness or death due to extreme barometric readings.

Yesterday another United Nations body, the Special Commission for the Revival and Enforcement of Western Enlightenment and Diversity (UNSCREWED) announced its action recommendations based on the UNCLE report. At a special press conference on the DICE problem, the chair of UNSCREWED, Dr. Luisa B. Gunweiller, blamed the inaccuracy of measuring instruments. “A large part of the problem is due to unreliable barometers,” she said. “Member states find themselves unable to respond effectively to the needs of minorities during climatological emergencies because barometric readings are so imprecise.”
- - - - - - - - -
Dr. Gunweiller proposes the scrapping of the traditional barometer and the implementation of new ethnically calibrated instrumentation, which will be designed and run by United Nations employees stationed in Ethnically Rich Zones (ERZs).

“I think you will see a dramatic reduction in the adverse effects of weather on minorities in the ERZs once the barometer is no longer in use,” said Dr. Gunweiller. “Employees who are specially trained to be sensitive to both climatic effects and the needs of ethnic groups can be more effective than barometers in the alleviation of DICE.”

UNSCREWED has forwarded a resolution to the General Assembly which prescribes the exact reforms to be imposed on member states, and a timetable for their implementation. The resolution is expected to reach a floor vote later this month.

Special UN correspondents Flobrunk Ebermajian and Dankwalder Clostrum contributed to this report.

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OK, I admit it: I made up Case Study #2. But still…

The point is that tinkering with the rating agencies or — worse yet — putting them under full governmental control will not solve the debt crisis that triggered the current financial meltdown.

Once upon a time, the three major bond rating agencies — Moody’s, Fitch, and Standard and Poor’s, the same ones the EU now objects to — charged a fee to potential customers for rating bond offerings and other forms of debt. It was a sensible, rational market-based system: when a lender — the buyer of a bond — needed professional advice on the riskiness of a particular debt instrument, he hired one of the rating agencies to do the job. The agencies competed with each other, so the accuracy of their ratings was the guarantor of return business.

All that changed with the automation of financial systems, especially after the Internet was established. The buyer could now find the information and rate the bonds himself — or at least have his in-house staff do the job — and save the fees paid to the rating agencies.

The agencies stayed in business by selling their “seal of approval” to the bond issuers, i.e. the borrowers themselves. This created a classic conflict of interest — a large financial house was more likely to use the agency that gave its debt instruments favorable ratings, so a rating agency had a vested interest in overlooking the shaky or shady aspects of bonds it rated.

This is how the sub-prime derivatives got their AAA ratings when the debt they were based on should have been rated ZZZ or lower. Everyone involved in the process had an incentive to be less than truthful about what he was doing, so the entire system careened towards the abyss into which we are now falling.

At every stage of the financial crisis, governments have consistently taken exactly the wrong actions, and an attempt to control the rating agencies is just one of them. Picking out scapegoats — bankers, CEOs, rating agencies — is easy to do, but the real issue is and always has been government meddling in banking and the financial markets. Every stage of the current catastrophe was marked by the passage of laws and regulations designed to control the financial markets, and every law and regulation was then exploited by savvy and unscrupulous operators who made a killing in those same financial markets.

Government control can only guarantee even more devastating results. Corruption is inevitable when the government runs markets; it is inherent in the system. Meddling with the flow of real information to ensure only desired results guarantees that the undesired results — which have merely been postponed, not eliminated — will do that much more damage when they finally arrive.

The United States and the European Union are making the same bad decisions — more government interference, more regulation, more central control — when it comes to fiscal matters. They see bad weather and a damaged barometer, and conclude that the only way to improve the weather is to destroy the barometer completely.

None of this will stop the gathering storm.

It’s no go my honey love, it’s no go my poppet;
Work your hands from day to day, the winds will blow the profit.
The glass is falling hour by hour, the glass will fall for ever,
But if you break the bloody glass you won’t hold up the weather.

— Louis MacNeice, from “Bagpipe Music”


Arius said...

If the West continues on its current insane path the time will come when case study #2 will be reality.

Henrik R Clausen said...

Am currently reading The Big Short. Main conclusion, halfway through the book:

Rating agencies should be abolished.

Their incompetence, and the blind faith that major banks (Deutsche Bank, anyone?) had in them, provided the main fuel for what became the 2008 financial crisis. Abandon the agencies, let investors evaluate risks themselves, and we'll have a much healthier system.

Baron Bodissey said...

Henrik --

I agree. There was a time when rating agencies had a valid business role, but since the arrival of the internet they are totally unnecessary. In fact, given the politcal meddling, they are harmful.

Anonymous said...

The borrower paying rating agencies is like me bringing a mechanic to asses the car I want to sell. It's a joke. And governments picking the rating agencies that are truth worthy is an even bigger joke considering that the agencies will be forced to rate the governmental debt better than it is. If I had a rating agency, the DOW would be a short and the bonds of Greece, Spain, Hungary, Romania, Italy, Ireland, UK, US, Portugal, France would be close to junk bond.

By the way Baron, at first you had me fooled with case study #2. But then it got even too ridiculous for the UN too. lol

Yorkshireminer said...

This says it all

Anonymous said...

April fool jokes are getting increasingly common on conservative blogs, regardless of the date of the day.

And the worst thing : sometimes, contrary to this one, they are not jokes.

Henrik R Clausen said...

In fact, given the politcal meddling, they [rating agencies] are harmful.

Understatement of the Month candidate!

Even without political meddling, they are deeply harmful. Take for instance the whole subprime mess, with Credit Default Swaps, Collateralized Debt Obligations and all that. Those advanced and obscure derivatives could never, ever have taken off without the approval stamp of the - government approved - rating agencies.

In this case, incompetence was fully sufficient to wreck havoc. Political meddling is worse yet.

Baron Bodissey said...

Henrik --

No part of the process was without political meddling. The subprime mess was only possible because the government created Fannie and Freddie, and then mandated that lenders hand out money to people who couldn't possibly repay it. All the while they in effect were guaranteeing that the two major players would never fail.

The rating agencies allowed everybody to pretend that these mortgages were as good as real mortgages.

This inflated the bubble by pouring vast quantities of debt into the real estate market, driving up prices, which -- collateralized as new mortgages -- added even further to the problem.

There was no point in this process that was not politicized. The issuance of the mortgages was driven by both ideology and greed, which conveniently met in the mortgage market. Ideologues could be satisfied by providing access to credit for those who had been "discriminated against". And every player got to make enormous profits.

It was win-win for everybody involved -- until the bubble burst. And it was ALL due to government meddling. It could never have gotten started without the corrupt interference of government at every step of the way.

Anonymous said...

Baron, you forgot one of the most important parts of it. The Fed artificially low interest rates! The subprime, negative ARMs and all those were created by the phony short term interest rates. If the interest rates weren't simply put there by fiat and were set by the market, all those people wouldn't have got loans with higher interest rates. Basically, all those exotic products were created by the horrid monetary policy of the Fed.

Baron Bodissey said...

RV --

I didn't "forget" about the Fed. I can't write about everything I'm aware of in every comment or post!

If I decided to write down every act of government malfeasance that caused the financial meltdown, it would take far more text than could fit into a comment.

And I can tell you a couple of things you "forgot":

(1) The mortgage interest deduction on federal income taxes. This favored middle-class homeowners, and was needed by the government to keep people buying overpriced houses and thus inflate the money supply, since all those houses were being collateralized on mortgage loans. More home buyers + more collateral + more loans = expanded money supply.

(2) Federal interference with private financial operations such as GMAC.

Every enterprise run by unscrupulous and/or stupid people -- including Fannie and Freddie -- should have been allowed to fail when its number came up. Then the system would have corrected itself. It would have been painful, but in 2-3 years the pain would have been over.

However, a lot of friends of Barack Obama, George Bush, Bill Clinton, Nancy Pelosi, Tim Geithner, Ben Bernanke, and George Soros would have taken huge financial losses if that had happened. We can't be having that, now, can we? So Too Big to Fail became the name of the game.

Anonymous said...

Baron, I didn't expect you to write about everything, of course. I was just completing the picture, since the Fed was the most important part of the mess. Even with all the rest, if the Fed would have had a sound monetary policy, this wouldn't have happened.

Baron Bodissey said...

Rebel --

You're right, none of this could have happened without the Fed's loose money policy. But all of the components were necessary -- it couldn't have worked without all of them being in place.

Some of the other absolutely necessary prerequisites that I can think of:

(1) Fannie Mae and Freddie Mac. These agencies had an unnatural leg up on the competition, plus the implicit government guarantee that they would never fail. The mandates that Congress applied to them fueled the bubble through lending to risky borrowers.

(2) Mortgage interest deduction for income tax, as I described above.

(3) Rating agencies beholden to the borrowers. This was necessary to pass off the risky loans as good ones.

(4) Relaxed SEC rules for banks and other institutions, that loosened capitalization requirements and allowed the creation of questionable debt instruments which enjoyed an implicit government guarantee through Fannie & Freddie.

There are probably other necessary components that I'm leaving out, but those are the ones that come to mind.

It was a perfectly designed system for fraudsters, scoundrels, and shysters. The smart ones would have cashed out at the peak, in about 2006, and then high-tailed it to the Bahamas or Costa Rica to live in luxury off the interest from their Swiss bank accounts.