Coyote Blog

Just six months ago, governments were criticizing ratings agencies for letting threats by debt security issuers cow them into keeping ratings for bad debt higher than they should be (emphasis added)

Moody’s and Standard & Poor’s, Wall Street’s two largest credit rating agencies, were roundly criticized in the Levin-Coburn Senate reportfor betraying investors’ trust and triggering the massive mortgage-backed securities sell-offs that caused the 2008 financial crisis.

Credit rating agencies are supposed to provide independent, third-party credit assessments to help investors understand the risks in buying particular securities, debts and other investment offerings. For example, securities that have earned the highest ‘AAA’ rating from Standard & Poor’s (S&P) should have an “extremely strong capacity to meet financial commitments” or have “a less than 1% probability of incurring defaults.” Investors would use the ratings to help evaluate the securities they’re seeking to buy.

However, the standard practice on Wall Street is fraught with conflicts of interest. In reality, the credit rating agencies have long relied on fees paid by the Wall Street firms seeking ratings for their mortgage-backed securities, collateralized debt obligations (CDOs), or other investment offerings. The Levin-Coburn report found the credit agencies “were vulnerable to threats that the firms would take their business elsewhere if they did not get the ratings they wanted. The ratings agencies weakened their standards as each competed to provide the most favorable rating to win business and greater market share. The result was a race to the bottom.” Between 2004 and 2007, the “issuer pay” business model fostered conflicts of interest that have proven disastrous for investors.

I have no problem with this analysis.  But it's ironic in contrast to the very same governments' reactions to their own downgrades over the last 6 months.  In fact, the general government reaction from Washington to Paris has to be to ... wait for it ... threaten the agencies in order to keep their ratings up.  And these threats go farther than just loss of business - when the government issues threats, they are existential.  It's hard to see how the US or French government's behavior vis a vis downgrades has been any different than that of banks or bond issuers that have faced downgrades.

In general, the tone of government officials has been "what gives them the right to do this to us?"  The answer to that question is ... the government.  These self-same governments were generally responsible for mandating that certain investors could only buy certain securities if they are rated.  And not just rated by anyone, but rated by a handful of companies that have been given a quasi-monopoly by the government on this rating business.

Michael Smith comments over at EconTalk on a comment by one Mark K (via Cafe Hayek)

Mark K wrote:

These jokers on Wall Street, who according to Russ made "˜innovative' products like credit default swaps, showed us unregulated free market capitalism in all its glory.

The notion that we have an "unregulated free market" is false.

If we had an unregulated free market, the organizations and individuals that made stupid investment decisions -- those "jokers on Wall Street" -- would now be bankrupt, to be replaced by more competent organizations and managers. Instead, under the current system, they are "bailed out" -- at your expense -- and allowed to continue operating.

If we had an unregulated free market, the investment rating agencies that rated securities containing subprime loans as "AAA" would be disgraced, bankrupt and out of business -- no one on earth would deal with them any longer -- they wouldn't be able to pay people to use their services. Instead, under our current system, not only are all those rating services still in business, the S.E.C. requires that all issuers of investments use those rating agencies.

If we had an unregulated free market, no one would be forcing bankers to make riskier loans than they wish to, as is currently done by legislation such as the Community Reinvestment Act and threats of lawsuits from organizations like ACORN and from the Federal Government"˜s Justice Department (Clinton"˜s DOJ filed 13 major lawsuits against banks for failure to lend to "minorities").

If we had an unregulated free market, there would be no central banking entity in charge of a fiat money supply with the ability to:

a) Make vast amounts of credit available at below-market interest rates.

b) Follow such a persistent policy of inflation as to convince virtually everyone in the country that purchasing a house is "a good investment".

c) Eliminate ( or at least significantly reduce) risk aversion by guaranteeing bankers that they (the Fed) will always be there as "lender of last resort".

d) Condone and make possible a preposterously over-leveraged fractional reserve banking system under which banks currently hold total reserves of only about 4% and are thus extremely vulnerable to any sort of a run or loss of confidence in the bank.

If we had an unregulated free market there would be no quasi-government entities like Fannie and Freddie and the FHA to insure that trillions of dollars of that cheap credit made possible by the Fed was directed into the residential housing market, producing an unsustainable boom in housing construction, which, when it ends, leads inevitably into an economic bust.

If we had an unregulated free market, the Federal Government would not now be contemplating looting the American taxpayers of another trillion dollars or so to pay off various special interests that helped the latest collection of looters get into power.

We don't have an unregulated free market. We have a "mixed economy", with a few elements of capitalism struggling under the weight of literally thousands of pages of rules and regulations and dozens of government agencies interfering in virtually every aspect of our economic lives.

And under this set-up, it is you, the "little guy", the individual who doesn't have a powerful lobby in Washington to get the rules bent in your favor -- you, who cannot command an audience with Congress to beg for your personal bailout -- you, who can do nothing as government uses your funds to save the incompetent and the dishonest from the consequences of their own actions -- it is you who gets screwed.

We don't have an unregulated free market; we have an out-of-control government intent on looting us blind.

Megan McArdle said a few days ago:

My reasoning for thinking of this as a depression, rather than a recession:  roughly, that we don't understand how to get in or out of it.

I have no doubt that unwinding serious problems with mortgage loans and the housing bubble would have pushed us into some kind of recession.  But one can easily argue that the bank failures in the 1980s and the housing market in places like Texas were far worse in the 1980's than they were in late 2008.  In fact, there is a fair amount of evidence that current mortgage and foreclosure problems are mainly limited to 4 states (Arizona, California, Nevada, Florida).

If one argues that we now have something worse than a run-of-the-mill recession (which I am still dragging my feet on admitting), then I think I know the cause:  economic hypochondria.  Yes, we may have a cold, but we have convinced ourselves it's cancer.

It all began with one man:  the US Treasury Secretary.  Who decided in October to scream to all the world that the US and all its financial institutions were facinig systemic disaster.

FDR did at least one thing I thought fairly clever.  One day, he declared a bank holiday, and told the country he was going to inspect all the banks.  And a few days later, a few were closed and the rest opened up, suddenly certified by the US Government as healthy.   He did exactly the opposite of Paulson - he faked it.  No way he really knew if all the other banks were healthy, but he saw a crisis of confidence and he bluffed.  The same way, in fact, Jeff Skilling bluffed (and went to jail for) when he faced a liquidity crisis and the leaders of Bear Stearns and many others have this year as well.  But Paulson screamed to the world "liquidity crisis" and we may not know much about how to get in and out of them, but we do know that such a statement is usually a self-fulfilling prophesy.

Once Paulson struck the match, everyone else had a reason to contribute to the fire.  Obama loved it, because a financial crisis could be laid at the door of Republicans.  The media loved it, because they always like to headline pending disasters and it supported their guy Obama.  Banks learned to love it, as they soon found that if the country bought the "disaster" story, they might get free government handouts.  And then GM and others saw an opening to stampeded the government into more handouts.  In one of the great ironies of all time, the looming depression became the greatest gravy train of all time, spawning what literally will be the largest pork-fest in all of history.

So what do the rest of us think?  Well, we might still have our jobs, but it sure seemed like we might lose them soon.  Just watch the news.  And our company joined right into the panic.  I have cut expenses and jobs like crazy in anticipation of a drop in revenue I haven't even seen yet!

Can I prove that this is anything more than just a libertarian fantasy-rant?  Not really.  The only potential proof I can offer is as follows.  If my story is correct, then we should see layoffs occurring faster than actual drops in output.  We should see job cuts in anticipation of, rather than as a result of, falling demand.  To which I offer these two charts, via Alex Tabarrok:

Postscript: To be fair, economists who look at this stuff much more deeply were calling out deep problems long before Paulson screamed fire in a crowded movie house (example).  I am not say we would not have had a recession, but the speed and depth of the drop may well have been affected by his mismanagement.

Under Bush:

• Iraq Invasion:  Hurry, we need this, emergency, rush, no time to argue, trust us
• Patriot Act and Related Legislation:  Hurry, we need this, emergency, rush, no time to argue, trust us
• TARP I:  Hurry, we need this, emergency, rush, no time to argue, trust us

Under Obama:

• TARP II:  Hurry, we need this, emergency, rush, no time to argue, trust us
• Stimulus bill(s):  Hurry, we need this, emergency, rush, no time to argue, trust us

Change we can believe in.

On a related note, Greg Mankiw looks at this graph in the TED spread:

And says:

[The TED spread's] decline suggests that the TARP is working and is certainly good news

Really?  You get all that from this chart?  I am not an economist, but I would have said the TED spread spiked up and came back down quickly in a very similar manner to any number of fear-induced price spikes, and had already fallen a fair ways before TARP was approved and had fallen a lot before the first dollar flowed (it is hard to read the chart, but by October 24 it had fallen to around 2.5).  This strikes me as pretty post hoc ergo propter hoc reasoning.  One could as easily say that the recent fall in oil prices was due to the most recent energy bill from Congress, but I am not sure even the most hard-core statist could say that with a straight face.

The longer-term history of the TED spread shows many such spikes, all of which came to earth quickly without a trillion federal dollars:

You see, kids, government has to closely regulate evil capitalists, because these capitalists sometimes make investment mistakes, like making highly leveraged investments in risky bubble assets.  The government must be the one to watch over their shoulder, because well-meaning public servants would never make such a mistake themselves:

The California Public Employees' Retirement System (CalPERS)is now warning California's cities that they may have to cough up more money to cover the retirement and other benefits the fund provides for 1.6 million state workers, reports the Wall Street Journal. Some communities are already cutting municipal services and they are blaming CalPERS, not Proposition 13. Dan Cort, mayor of Pacific Grove, has been quoted as saying, "CalPERS could bankrupt us faster than anything else."

According to the Journal, CalPERS has lost almost a quarter of the $239 billion in assets it held in June of this year. Stock market losses are an obvious cause of the fund's distress, but less well known is that CalPERS makes extensive investments in real estate -- investments that have been largely financed by borrowing. Some deals involved as much as 80 percent of borrowed money. While this worked well in a rising market, now that real estate has tanked CalPERS expects to report paper losses of 103 percent on its housing investments for the fiscal year ending in June.

Note especially the text in bold.  It takes some effort to lose more than 100% of your investment in one year.  They would have been better off investing with Bernie Madoff, since a 100% loss would have been better than 103%.

The inherent flaw in every call for government action is not the "insight" that business people sometimes are wrong, even way wrong.  The flaw is assuming that anyone in government is more capable, or has superior incentives, to make better decisions.