Archive for the ‘credit’ Tag

The Core of the Credit Matter and the importance of the little fish

I am no good with opening words and this is my first blog entry anyway, so whoever reads this will excuse the lack of a witty first sentence (I hope this doesn’t damn me to exile from the blogosphere’s witty elite).

Anyway, I wanted to tackle here the issue of credit rating agencies and their role in the securitization market for two reasons. First, it has received a ton of attention lately, but that attention has been too narrowly focused. Second, we are starting to see action on Capitol Hill and its likely that some form of new legislation regulating the credit rating agencies before too long. So let’s start from the beginning…

First, realize one very important thing. The process of securitization, through which an asset such as a home loan is transformed into something that can be sold freely on the open financial market, has one feature that grossly distorts the markets: it creates “information gaps”. Take for example a bank that makes 100 loans to Regular Joes all over the state of Ohio. The bank will then take the loans (aka the money that the Regular Joes owe the bank), pool them together into a single “batch” and sell them to an investment bank or to Freddie Mac. The investment bank can then set up a “special purpose vehicle”, which will divide up the batch into a bunch of smaller batches and then sell to investors on the open market. This is the life of a “Collateralized Debt Obligation” and it allows investors to participate in the credit game.

The problem here is obvious: the final investors is very far removed from the original borrower. Regular Joe’s loan has gone through the hands of a loan officer, then a bank, then the investment bank, then the special purpose vehicle, and finally to the investor. This means that the final investor has absolutely no personal relation to the borrower whatsoever. He knows next to nothing about the Regular Joes who now owe him money. So the investor relies on a credit rating agency to bridge this enormous gap and provide him with information regarding the reliability of these Regular Joes.

And now we get to the core of the problem. Lawmakers and media pundits have complained that because the credit rating agencies actually get paid by the investment banks that sell the “batches” of loans, those agencies are inclined to make friends with the investment banks by giving their “batches” high credit ratings. Is this a problem? Undoubtedly. But its only half the problem.

The real issue is the “information gap” that I mentioned earlier. Credit rating agencies are supposed to provide investors information about the reliability of the Regular Joes whose loans investors are buying, but they can’t because the credit rating agencies rely on information provided by the investment banks to make their credit rating decisions. This means that the agencies themselves are far removed from the original borrowers. No credit agency would take the time to go to the home of each Regular Joe and interview him or collect information about his job stability and ability to pay off his loan. This means that there is a fundamental, structural problem in the system that the credit rating agencies cannot repair.

So even if we change the way credit rating agencies get paid and even we forbid them to receive money from the investment banks, the core problem will not go away- the information gap will remain. Investors will still have limited information because the credit rating agencies on which they rely will have limited information as well. If we really want to repair the system we need to look further down the securitization line at He Who Is Responsible For The Loan In The First Place: the loan officer. If anyone thinks that credit rating agencies have the wrong incentives, then how about the loan officers and their employers- the mortgageĀ originators. They get paid based purely on the amount of loans they dish out. They have little incentive to vet their borrowers properly and they have very little incentives to withhold loans from anyone.

Therein is the true problem. The information gap will continue to exist until major changes are made to the way originators operate. You can’t count on credit rating agencies doing a good job so long as they are far removed from the borrowers that they are actually evaluating. You have to count on the people who are closest to the borrowers in the CDO supply chain. That’s why we need to shift our focus a bit.

So don’t damn the credit rating agencies- realize that no matter what we do about the way they get paid, the structural problem in the system will persist until the information gap is repaired.