Thursday, April 22, 2010

Ratings Agency Thought Experiment

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).