Dish Check Update: Who Caused The Financial Collapse?

A dissent of sorts, nudging the blame away from the banks:

I have been involved in the mortgage-backed securities market for about 20 years.  Your conclusion that the government did not force the banks to make bad loans is absolutely correct.  Mayor Bloomberg's remarks, for whatever reason, are absolutely false. However, the analysis and blame are much more complex.  By making this an argument of Banks v. Government, as the Tea Party and Occupy Wall Street seem to make, and which the media perpetuates, is too simplistic.

While "the banks" share some of the blame and some banks misled some investors on some deals, I believe those cases were generally isolated and may have slightly exacerbated the problem, but did not cause the problem.  It was a breakdown of the system that caused the problem.  If a bank tells investors that they are investing in a pile of shit (subprime mortgages) and the investors buy them, why should the banks get the blame? 

Even if the bank knows it is selling a pile of shit and separately bets against it, as long as it adequately discloses that it is selling a pile of shit, that is how our market works.  As a capitalist, you can't blame the banks.  If they fail to disclose that they are peddling a pile of shit, they are liable civilly and criminally.  So far, surprisingly, there have only been isolated (though well publicized) cases brought against the banks for misleading investors. 

Why did the banks sell piles of shit?  Because of the Wall Street compensation system that pays annual bonuses upon closed deal, regardless of whether those deals go bad.  They made a lot of money doing so.  The bankers who were more responsible and did not peddle piles of shit were fired for not making as much as their competitors.  So there was a race to the bottom to sell the most piles of shit.

Did the banks believe those deals were bad?  Yes and no.  To a certain degree, the banks knew that there would be some amount of decline in value of bonds they sold, but not to the degree that actually occurred.  One of your comments is a bit off – that the deals were designed to work in a market that never faltered.  That is not quite right.  They were designed for some level of decline, but not the catastrophic level that occurred.  It is an open question as to how stinky the bankers thought their piles of shit were.

I don't find the banks totally blameless, but there are many others to blame:

The investors.  These are not your mom and pop investors, but very sophisticated pension funds and others.  Astoundingly,  I would hear at conferences that they were "chasing yield," which meant that they were seeking higher returns, which meant that they were looking to buy, in my view, risky shit.  Which is why the bankers could sell them a pile of shit.  Further, many of the investors also suffered from the generational issues.  The younger ones did not think that real estate would go down because they never lived through a market crisis and the older ones did not understand the complexity of the new-fangled deals that were being done.  So these sophisticated investors, while thinking they were taking on some risk, took on more risk than they thought.  In their defense, partially, they were buying rated securities.

The rating agencies, along with the complicit investors, also deserve a lot of the blame.  From the early 1990s to the mid 2000s, the deals were getting riskier and more complex, yet the agencies were giving these deals higher ratings.  It was the rating agency imprimatur that allowed the banks to turn a pile of shit into golden nuggets.  Once again, the blame was due to compensation. The banks would shop around to the various agencies to get the best ratings, creating a race to the bottom.  If the ratings were too low, the agencies would not get paid or would not get future deals.  The "false" ratings colored the market and left the regulators asleep.

But the blame goes further.  The deals could not get done without inflated appraisals on properties.  Once again, appraisers felt the need to give inflated appraisals in order to get future business from the mortgage companies, making them co-conspirators. As someone who refinanced his house several times, I always found it interesting that the appraisal always came out to an amount which allowed the bank to lend me the amount requested.

Then there is the public.  Although there is some percentage of homeowners who needed the money for medical emergencies or other legitimate reasons, for about a decade, the American public treated their homes as ATMs.  Nobody forced anyone to take out a loan. Yes, there were some folks who were duped and took out adjustable rate loans that they did not understand, but who gets the blame for public ignorance? Many of these same people then took some of the proceeds and were further ripped off by unscrupulous auto salesmen or timeshare companies.  Are we also blaming them?  And the people ripping off the public were not the Wall Street banks necessarily, but rather the local mortgage companies and local banks.  

Then there was the government to the degree you noted, but in my view the government was more asleep than complicit.

More on ratings agencies from another reader:

Once upon a time, agencies like S&P and Fitch were paid by people interested in buying the rated securities. But nowadays, the originator of the bond (or MBS or CDO or CDO squared) pays for the ratings. Since these agencies compete for business, a perverse incentive was introduced into the ratings system which distorted the legitimacy of their judgments. Add to that the truly oceanic complexity of many of the mortgage and credit-backed securities being floated, and you get a failed rating system in which special statistical analyses of a pile of faulty loans lead to excellent ratings. You get enough shit in a bucket and there’s going to be some gold in there somewhere.

Another shifts that blame a bit more:

The federal government is at fault for allowing the issuers of these securities to pay for their ratings.  There is no reason why rules are not in place, via the SEC (although the FDIC, OCC, or OTS could also be involved) that prohibit this. Investment ratings should be purchased on the open market such that would-be buyers of MBS investments pay an agency to rate the risk of potential securities to be purchased. You would not buy a home certified to be in excellent condition if said certification were performed by a home inspector selected and paid by the seller of the property.  Why should securities purchased by public and private pension and retirement plans, foundations, or the insurance companies from whom you and I buy home, life, and auto insurance be treated any differently? (Refer to this article by Thomas Donlan for an explanation of how the SEC's treatment of S&P, Fitch, and Moody's makes it complicit in allowing the financial crisis to happen.)

More reader input here and especially here.