In the old days, if you wanted to buy a house, you went to a bank. The bank would assess your ability to repay the 1oan and collect a down payment to ensure that you had some "skin in the game." The bank typically held the loan, providing an incentive to ensure that a borrower wouldn't default.
In short, all the players had a stake in the success of the borrower repaying the loan.
That system, however, was thrown out the door in favor of a new system where no one had a stake in the success of a mortgage loan.
Lenders marketed loans that required little or no down payment and little or no documentation of income and assets. Middleman brokers who steered borrowers to these higher-cost loans would get fees, regardless of the borrower's ability to repay.
And lenders shifted from the old "book-and-hold" model (in which the original lender continued to hold the mortgage) to an "originate-to-distribute" model, in which the lender held mortgages briefly and then sold them to Wall Street firms, which in turn packaged them to sell to investors.
As a McClatchy investigation in Sunday's Bee shows, this house of cards was hugely dependent on credit rating agencies (Moody's, Standard & Poor's, and Fitch), which gave the highest triple-A investment grade ratings to these pools of risky home loans.
"How Moody's sold out investors" in Sunday's Bee shows not only that credit rating agencies turned a blind eye to inflated, unsound ratings of mortgage securities but dismissed, silenced or punished analysts who warned of problems.
What should be done to see that this does not happen again?
As Sunday's story shows, a large part of the problem comes from inherent conflicts of interest when those who are packaging securities are the same people who are paying the fees to the credit rating agencies. Not surprisingly, they go "rating shopping" to choose the credit rating agency with the lowest standards.
The Obama administration has proposed reform legislation, which is making its way through Congress. The Securities and Exchange Commission would review credit rating agencies once a year. Banks would have to disclose all preliminary ratings they receive from credit rating agencies in an attempt to stop banks from shopping for the best credit rating for their products. Credit rating agencies would have to disclose the fees they received for a particular rating.
The legislation also proposes that an interagency team examine the current reliance of investors on ratings.
Others want stronger medicine. For example, Frank Partnoy at the University of San Diego School of Law believes Congress should eliminate credit rating agency exemptions from liability. Treat them the same as accountants if they engage in negligent, reckless or fraudulent practices. The credit rating agencies are fighting this, saying that they merely provide "opinions," and that no one should rely on their ratings to make investment decisions.
More disclosure, at a minimum, is essential – as is the need to reduce investor reliance on the current rating agencies. Congress should adopt such proposals first. If they fail, the hammer of liability waits in the wings.
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