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“Comrades, I beg of you, do not resort to compulsory taxation. There is no worse tyranny than to force a man to pay for what he does not want merely because you think it would be good for him.”     Robert A. Heinlein,    The Moon is a Harsh Mistress

May 13, 2010

Prosecutors Ask If Congress Duped CBO To Obtain Favorable Score

by Brad Warbiany

Okay, that’s not true. But it’s no different than this:

Prosecutors Ask if 8 Banks Duped Rating Agencies

Wall Street played a crucial role in the mortgage market’s path to collapse. Investment banks bundled mortgage loans into securities and then often rebundled those securities one or two more times. Those securities were given high ratings and sold to investors, who have since lost billions of dollars on them.

At Goldman, there was even a phrase for the way bankers put together mortgage securities. The practice was known as “ratings arbitrage,” according to former workers. The idea was to find ways to put the very worst bonds into a deal for a given rating. The cheaper the bonds, the greater the profit to the bank.

The rating agencies may have facilitated the banks’ actions by publishing their rating models on their corporate Web sites. The agencies argued that being open about their models offered transparency to investors.

But several former agency workers said the practice put too much power in the bankers’ hands. “The models were posted for bankers who develop C.D.O.’s to be able to reverse engineer C.D.O.’s to a certain rating,” one former rating agency employee said in an interview, referring to collateralized debt obligations.

I just finished reading Michael Lewis’ The Big Short, and it’s pretty clear that the banks knew enough about the rating agencies’ models to pretty successfully turn shit into shinola. In fact, the agencies made enough of their ratings models public to make it absolutely certain that the banks would game the system. Not *dupe* the rating agencies, mind you, because the ratings agencies were willing partners.

But I thought about it a little bit more, and I was struck by another thought.

The Democratic house leadership wanted to cost projection of the healthcare bill to come in within a certain number. So what did they do? They duped gamed the CBO rating system to ensure that the bill they wrote would have the price tag they wanted it to have. The CBO is a respected and non-partisan office, but they’re asked only to score what legislators give them, NOT what they think the legislators will do in other bills immediately or a few years down the line.

Essentially both the Wall Street banks and Congressional leadership did the same thing: they were teaching to the test. They knew specifically what was needed in order to generate a favorable outcome from the “test”, and they made sure they did exactly what they wanted, but in such a way that got the right score.

So who’s going to prosecute the Democratic leadership when this healthcare bill inevitably costs the American people more than they advertised?

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6 Comments

  1. I don’t understand the problem. If there was transparency across the board, then the fault lies with the buyers for not doing enough research to tell if the securities were worth the going rate. Likewise for voters and the bill.

    Comment by Jeff Molby — May 13, 2010 @ 12:36 pm
  2. So Jeff, I take it that every time you buy a new piece of electronics, you carefully review the UL test reports to ensure that the product won’t burn down your house, right? Or do you just trust that UL is a respected institution and won’t certify a product that they, as experts in the field, know is bad?

    While I’m sympathetic to your argument, as I am a believer in personal responsibility as the final determinant of the “justice” of a situation, I’m not willing to let the rating agencies off the hook. While ultimately the one who bears the brunt is the buyer, a UL certification, or a AAA rating should mean something. That it ceased to do so was a failure of the rating agencies.

    Likewise the buyers of these MBS & CDO products, given that they’re shelling out a lot more money than I do for a stereo, should have known what they were getting into. Especially when these investment banks were packaging up crap to sell, and then on the other side of their houses were BUYING the same crap packaged by other morons. The strangest thing about this meltdown is that banks who should have known better about what these CDOs contained ended up holding on to the live grenade and getting blown to bits.

    In one sense, you’re right. Ultimately, it’s caveat emptor. In another, though, you’re seeing what were once very trustworthy rating agencies who were part of and enabled a massive failure. The rating agencies failed to properly detect risk, because they used bad assumptions about housing values and economic trends (i.e. that foreclosures were uncorrelated — overestimating the “diversification” of the CDOs they rated) and at the same time fell victim to conflicts of interest. Frankly, they simply blew it.

    Comment by Brad Warbiany — May 13, 2010 @ 2:02 pm
  3. The key is in your first paragraph. If they knowing inflated ratings, sure, hang ‘em high. If, otoh, they simply made the same mistaken assumption that a llllllllot of people made — that house prices wouldn’t plummet across the board — then they’re only partially to blame. If their criteria was made public and few, if any, analyst-type people said, “wait just a minute! Your criteria suck!” at the time, I can’t see how you can assume they were very far from conventional wisdom. Sure you can argue that they should be even better than conventional wisdom, but that’s closer to a nitpick

    Comment by jeff molby — May 13, 2010 @ 3:46 pm
  4. Actually, I think Congress’s gambit with the CBO is a fair amount worse than banks gaming the rating agencies. As Jeff rightly points out, buyers could refuse to buy the shit-turned-shinola from the banks. Voters still haven’t gotten a say on health care…

    Comment by Quincy — May 13, 2010 @ 5:11 pm
  5. Well, Jeff, you do have me there. Whenever someone opposite the conventional wisdom, like Peter Schiff, explained exactly what was going on, they made him seem like a doom-saying quack. Or, for that matter, what I said here. I’m a layman when it comes to economics, but look at about 2/3 of what I predicted has already come to pass — and with the current mess in the EU, nobody knows whether there are more shoes to drop to fulfill the rest of them.

    *Knowingly* inflate ratings? Not quite. They set the table, told the banks what would score well, and then the banks played as hard and fast with the rules as they possibly could to put together securities to get the highest ratings possible. And if they didn’t get the right answer from Moody’s, they went to S&P, or vice versa. Clear conflict of interest against the ratings agency that might “call the bluff”, if you will. And Congress? What incentive did they have to blow the whistle when all this loose money was pushing up GDP and driving American homeownership to “historic” levels?

    There were a lot of issues. What really happened is that all the checks in the system (the rating agencies being a big one of those) failed. The rating agencies in particular failed because they basically gave the banks the roadmap to game the system (much like the CBO does for Congress, which was the point of the post).

    Comment by Brad Warbiany — May 13, 2010 @ 8:19 pm
  6. “What really happened is that all the checks in the system (the rating agencies being a big one of those) failed.”

    And possibly the biggest check in the system, bankruptcy (and the commensurate creative destruction) also failed, thanks to bailouts from those same folks in Congress.

    On the HealthCare/CBO side of the analogy, Americans have a chance to avoid the same mistake in at least one way: Fire as many of the bankrupt Congresspeople as possible.

    Sadly, we have precious few “green shoots” to follow that kind of political creative destruction. Just red shoots and blue shoots.

    Comment by Akston — May 13, 2010 @ 9:09 pm

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