The stakes here are enormous. After reviewing 20,000 pages of documents and e-mails from S&P, the Justice Department says that S&P hyped ratings of residential mortgage-backed securities (RMBS) and collateralized debt obligations (CDOs) to generate business. Banks and investment banks selling the securities pay for the ratings; higher ratings would attract more buyers. So S&P delayed introducing new risk models that would have lowered ratings, says Justice. S&P’s advice was not “independent” as claimed but was tainted by the pursuit of profits. Each CDO rating fetched fees from $500,000 to $750,000.
S&P calls the complaint one-sided. Hardly anyone, S&P says, anticipated the devastating crisis. The initial ratings were mirrored by other agencies. As mortgage delinquencies rose, ratings were revised. In 2006, S&P downgraded 400 RMBS ratings.
The suit reflects the conspiracy theory of the crisis: Sleazy bankers, waving distorted ratings, sold overvalued RMBS and CDOs to unsophisticated investors. It’s a seductive story contradicted by the facts. As Bloomberg columnist Jonathan Weil has written, many banks and investment banks that sold these bonds also bought them for their own portfolios. They thought the bonds had value. These included Citigroup, Merrill Lynch and Bank of America. By mid-2008, the 20 most exposed financial institutions had suffered nearly $300 billion in losses, according to Bloomberg.
It wasn’t just bankers who misjudged mortgages. So did global banking regulators. Under the so-called Basel rules, banks are required to hold $8 in capital for every $100 in ordinary consumer and business loans. (Capital is a buffer against losses.) But residential mortgages were considered sufficiently safe to justify a requirement half that — $4 per $100 loaned. These rules remain in effect.
Paradoxically, the financial crisis’s real origins lie in the economy’s good performance and its corrupting effects on public opinion. By 2007, the United States had experienced only two modest recessions (1990-91 and 2001) in a quarter-century. Since 1990, the unemployment rate had averaged 5.4 percent. Economists touted the “Great Moderation,” signifying fewer and milder slumps.
With a more stable economy, risk seemed to diminish. People could borrow more because their repayment prospects were better. Another consequence was a growing belief that “house prices would continue to rise rapidly for the foreseeable future,” write economists Paul Willen, Christopher Foote and Kristopher Gerardi in a paper for the Boston Federal Reserve Bank. As this notion took hold, it was “not surprising to find borrowers stretching to buy the biggest houses they could and investors lining up to give them the money.”
By the logic of rising prices, housing was a fail-safe investment. Homeowners would reap huge profits from higher values. Lenders would earn interest and, in case of default, be protected against losses by increased prices. These ideas created a “collective self-fulfilling mania,” argue Willen, Foote and Gerardi. Credit standards were eased; permissive practices — sloppy, reckless and sometimes illegal — grew. But they were more consequence than cause of the housing boom, which lay in the mass psychology of prolonged prosperity.
This is a subversive theory, because it implicates millions of Americans and deprives us all of a self-righteous sense of victimization. Good events conditioned us to have bad expectations.
Until the bubble burst, few understood what was happening. Fed Chairman Ben Bernanke recently admitted that he was caught off guard by the crisis. But the Obama administration holds S&P to a higher standard. There must be villains, and they must be punished. Someday this case may be settled. But for now S&P is a scapegoat, and the Department of Justice has become the Department of Blame.
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