The Myth of Expert Advice - Part 3

Mike Dever

"The Ratings Agencies"

In Part 1 and Part 2 of our series entitled "The Myth of Expert Advice", we discovered that "experts", people who make it their job to un­der­stand and forecast markets or events, are usually no better at their jobs than dart-throwing monkeys. 

In the first two parts, we focused on individuals offering prognostications or expert advice.  We now take this analysis one step further and expose the fallacy of expertise in an entire industry!

Background of the Ratings Agencies

When a company wants to raise money but not dilute its share­holders through the issuance of stock, one way for it to do so is to is­sue notes or bonds (NYSEArca:AGG - News). For centuries, the buyers of corporate notes and bonds (we'll simply refer to these as "bonds") relied on their individual skill (or luck) to evaluate the ability of the issuing company to make the obligated in­terest and principal payments. Eventually however, the quantity and complexity of new bond offerings created the opportunity for special­ized firms to fill the analysis role. These firms, which today include the big three of Stan­dard & Poor's [part of (NYSE:MHP - News)], Moody's (NYSE:MCO - News), and Fitch (part of ISIN Code: FR0000037947), began provid­ing ratings on railroad bonds in the early 20th century.[i]

Initially, the customers of these bond ratings were financial insti­tutions looking to buy bonds. They paid the ratings agen­cies for their analysis. That began to change when, in the 1930s, federal regulators began using the ratings to evaluate the soundness of the bonds held by banks. Because of this, any company that wished to have their bonds purchased by banks was essentially required to get each of their bonds rated. As a result, the business model of the rating agen­cies shifted. In­stead of getting paid by the purchasers of the bonds, they be­gan to require payment from the issuers of the bonds in order for those issuers to receive the required rating on each of their bonds.

This "issuer-pays" model, despite the obvious conflicts it created, became formalized in 1975 when the U.S. Securities and Exchange Commission deemed certain ratings firms to be "nationally recognized statistical rating or­ganizations" (NRSROs).[ii] It became increasingly necessary to receive an NRSRO rating before various government agen­cies or commer­cial banks could purchase a bond. It also became standard practice for buyers to rely on the ratings assigned to each bond by these NRSROs, rather than conduct their own individual due diligence. In other words, they subrogated their own re­search responsibilities to the research conducted by the "ex­perts" – the rating agen­cies. As long as a bond was sufficiently rated by an NRSRO, the individual responsible for buying that bond at a bank or government agency was unlikely to lose their job if the bond de­faulted.  They were simply following the rules as estab­lished over the years through government regulations and in­dustry convention. This subrogation of not only due dili­gence but also common sense, led to the near-collapse of the world's financial system. This chain of events, at its most fundamental level, was supported by the ratings provided by the NRSRO "experts."

Between 2002 and 2007, banks (NYSEArca:KBE - News) lent an estimated $3.2 trillion to homeowners with bad credit and undocumented incomes.[iii] Despite the obvious irrationality of this activity, the process of making bil­lions in bad loans was comprised of a sequence of individually ra­tional acts.

A home loan often starts with your typical main street mortgage brokers. They get a commission for matching up home buyers or ex­isting home owners with lending institutions (Originators). Their primary mission is to get a deal done. And they know just how to do it.

With commission in hand, the main street mort­gage broker faced no risk whatsoever if the homeowner ulti­mately defaulted on his or her mortgage. That risk now fell to the bank which lent the money. But they too were able to, liter­ally, pass the buck. They did this by bundling their sub­prime loans and selling them to other fi­nancial institutions. The buy­ers were quite often Fannie Mae and Freddie Mac.

Fannie & Freddie

Fannie Mae (OTC:FNMA.OB - News), the colloquial term for the Federal National Mort­gage Association, and Freddie Mac (OTC:FMCC.OB - News), the Federal Home Loan Mort­gage Corporation, are United States Government Sponsored Enterprises (GSEs).   When they were founded, the two firms were not offi­cially owned or backed by the U.S. government; however, this GSE designation means that they were sponsored by the govern­ment in order to help create a liquid secondary mortgage market. They did this primarily by pur­chasing mortgage loans from origina­tors such as commercial banks. This freed up the banks' capital, ena­bling them to make additional loans to homebuyers.

Fannie and Freddie, in turn, would finance their purchases by se­curitizing their acquired mortgages into mortgage-backed securities (MBSs). A securitization occurs when Fannie or Freddie buys mort­gage loans from originators and then bun­dles them into MBSs. Those MBSs, in turn, are sold to banks and other institutions looking for high-yielding securities with the implicit backing of the U.S. govern­ment.

That implicit backing became explicit in 2007 when the U.S. gov­ernment began to infuse billions directly into both GSEs,[iv] and the U.S. Federal Reserve purchased trillions of dollars of MBSs in order to prevent what they believed would be a total collapse of the global economy.[v]

But Fannie and Freddie were unable, due to their under­writing stan­dards, to pur­chase many of the riskier subprime loans that were being provided to homeowners during the housing boom of 2002 - 2007. As Daniel Mudd, then presi­dent and CEO of Fannie Mae, testified in 2007, "Unfortu­ loans in the subprime market did not become the standard, and the lending market moved away from us. Bor­rowers were of­fered a range of loans that layered teaser rates, interest-only, negative amortization and payment op­tions and low-documenta­tion requirements on top of floating-rate loans."[vi]

So while many subprime loans were purchased by Fannie and Freddie, an increasing percentage were classified as non-conforming, meaning they did not meet the requirements that enabled them to be sold to Fannie and Freddie. This increased the need for a market that enabled the securitization and sale of these loans.

Firms like Bear Stearns and Lehman Brothers stepped into the breach. But there was little demand from their clients for low-rated subprime securities. By consulting with the "ex­perts" (i.e. the ratings agencies), the in­vestment firms were able to determine how to structure the worst of the subprime mort­gages into securities that would receive invest­ment-grade rat­ings, often triple-A. This securitization process en­abled those firms to not only find buyers for the securities, but to sell the securities for prices be­yond any they would have received as subprime debt.

What happened??? . . .Stay tuned for the next installment in our series of "The Myth of Expert Advice"..

This article is excerpted from Myth #13 of "Jackass Investing:  Don't do it.  Profit from it." by Michael Dever. 

About the Authors:

Michael Dever is the CEO and Director of Research for Brandywine Asset Management, an investment firm he founded in 1982.  He is also the author of "Jackass Investing:  Don't do it.  Profit from it.", which is the Amazon Kindle #1 best-seller in the mutual fund and futures categories.  John Uebler is a Research Associate for Brandywine Asset Management. 

[i] Lawrence J. White, "A Brief History of Credit Rating Agencies: How Financial Regulation Entrenched this Industry's Role in the Subprime Mortgage Debacle of 2007 – 2008," Mercatus on Policy, Mercatus Center – George Mason University, No 59 (October 2009): 1.

[ii] White, "A Brief History of Credit Rating Agencies: How Financial Regulation Entrenched the Industry's Role in the Subprime Mortgage Debacle of 2007 – 2008:" 2.

[iii] Elliot Blair Smith, "Bringing Down Wall Street as Ratings Let Loose Subprime Scourge," Bloomberg (September 24, 2008).

[iv] "Fact Sheet: Government Sponsored Enterprise Credit Facility", U.S. Treasury Department Office of Public Affairs (September 7, 2008).

[v] "Agency Mortgage-Backed Securities Purchase program," Federal Reserve Bank of New York. Retrieved February 14, 2011.

[vi] Daniel H. Mudd, "Opening Statement" (testimony before the U.S. House Committee on Financial Services," April 17, 2007).

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