I am posting this with a h/t to Barry Ritholtz over at the Big Picture who gave me an idea with his post on Fannie Mae regarding what would have happened had we completely removed FNM from the picture. I want to run a similar thought experiment, but replace FNM/FRE with the "ratings agencies" (ie Fitch, Moody's, and S&P).
Facts: The ratings agencies fell over themselves to give virtually all MBS "aaa" ratings no matter what the composition of the underlying assets (see ABACUS for a great example).
The Hypothetical Counter Factual: Way back when the first MBS is presented to the ratings agencies that has even one slice of subprime/alt-a/NINJA in it the agencies gave the MBS a rating less than "aaa" and further marked them down more based on the share of non-prime loans. The idea being that if a MBS comprised entirely of fully amortizing prime loans is "aaa", then anything even a bit less than that cannot get a "aaa" rating.
Question: Would the housing bubble/bust have still occurred? Would we have had a credit crisis? Would banks have fought over themselves to make any loan they could? Would it have even had to come down to the regulators?
Since I believe the answer to all these questions is in fact NO, then it seems to me we may have the root cause of our problem (and one that is not addressed in the "reform" package).
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The problem is that if one ratings agency refused to give AAA ratings, then the seller of the MBS would have gone to another, and kept going around until they got their AAA rating. The incentives for the rating agency all run against giving low ratings, regardless of merit.
So these are the institutions that made the fraud possible... Is there anyway that we could have detected them ? An accounting way to view which institution has been creating lots of money/credit ?
That being said, detecting bubbles doesn't seem to require that much effort : they always are many books published on the subject. What's harder is the timing of the bubble.
Having AAA ratings on these instruments allowed them to tap the coffers of big pension funds and other more risk adverse investors. Without that possibility, the banks wouldn't have been falling all over themselves to get high yield high risk loans. As such there would have been less buyers for homes and prices would have grown at a more stable and sustainable pace. There might have been a bubble, but not nearly as big or as dangerous as this one got.
However, this is purely an abstract thought problem because you cannot make that scenario happen. So long as the people writing the checks to these ratings agencies are the ones who have the securities to be rated, they will be pressured to inflate ratings.
My suggestion here is that you open up the field to have more credit ratings agencies, however, they will all be subject to a strict regulatory regime. They will have to meet certain hurdles in order to get certified, and once certified they will be subject to period random audits. If the government finds any irregularities or inflation of ratings, then two things happen:
1) The company loses its ratings license thus effectively killing it's business
2) Executives of the company will be subject to clawbacks for any money earned during the period in question
The only way to eliminate the profit motive problem is to make the consequences of corrupt activity so catastrophic that nobody will take the chance. This will make the agencies more conservative and that will mean less risk taking, but I'm fine with that.
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