In Part 1-3 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, and we set the scene for the subprime crisis.
So, what happened???
Well . . . to summarize, we had main street mortgage brokers who had more than enough motivation to get their clients' loans approved, while avoiding any associated responsibility from the moment they received their commission checks. Their sole incentive was to get each loan approved, not to ensure it was ever repaid. We had the banks (NYSEArca:KBE - News) and other originators who loaned the money to the homeowners, but then resold the majority of those loans to Fannie (OTC:FNMA.OB - News), Freddie (OTC:FMCC.OB - News) and securitizers such as Bear Stearns and Lehman Brothers. Their incentive was to collect fees upon issuance of the loan, and to make sure its structure fell within guidelines that allowed it to be resold, thereby eliminating any risk to themselves in the event of homeowner default. Fannie, Freddie and the securitizers then bundled the loans and sold them to the end investor, such as pension funds and, interestingly, banks. Those firms were able to purchase the securities for one reason - they were rated by the NRSROs as investment grade. This begs the ultimate question. If the loans were subprime, with many likely to default in the event of a housing market (NYSEArca:VNQ - News) collapse, why did the credit agencies stamp them as investment grade? The answer requires us to circle back to expose the flaw in the structure of the ratings agency business.
The early 2000s saw credit rating agencies earn an ever-increasing percentage of their revenues from, as stated by then-SEC Chairman Christopher Cox in 2007, the "lucrative business of consulting with issuers on exactly how to go about getting''[i] top ratings.
So now they had two substantial revenue sources, one from charging issuers to rate their securities, and a second one from consulting with those issuers on how to structure those securities to receive the highest rating. This system resulted in obvious conflicts of interest. If your company was looking for a strong rating on a new bond (NYSEArca:AGG - News) issue, who would you call? . . . A rating agency that's been super tough on you in the past, taking a hard line and likely to give you a low rating based on your perceived potential risk? . . . Or an agency that has been "kind" in the past and made things happen? Of course, firms will seek out the rating that reflects most favorably on their business. This results in a "race to the bottom" in the quality of credit ratings, where each rating agency is financially motivated to appease their clients (or potential clients).
The total disregard for ethical business standards and the widespread greed that fueled this overt conflict of interest came into the spotlight in the credit crisis of 2008. The result was that the agencies were not motivated to rate the long-term prospects of repayment of the CMOs they had rated, but rather, in their own words, provide advice that constituted a "point in time" analysis.
This financial alchemy worked wonders. According to Inside Mortgage Finance, the annual volume of mortgage securities sold to private investors tripled to $1.2 trillion between 2002 and 2005. The subprime portion of the CMOs rose fourfold, to $456.1 billion.[ii] In the opening remarks at a hearing in 2010, Phil Angelides, the Chairman of the Financial Crisis Inquiry Commission, stated that:
From 2000 through 2007, Moody's (NYSEArca:MCO - News) slapped its coveted Triple-A rating on 42,625 residential mortgage backed securities. Moody's was a Triple-A factory. In 2006 alone, Moody's gave 9,029 mortgage-backed securities a Triple-A rating. That means they put the Triple-A label on more than 30 mortgage securities each and every working day that year. To put that in perspective, Moody's currently bestows its Triple-A rating on just four American corporations. Even Berkshire Hathaway (NYSEArca:BRK-A - News), with its more than $20 billion cash on hand, doesn't make that grade.
We know what happened to all those Triple-A securities. In 2006, $869 billion worth of mortgage securities were Triple-A rated by Moody's. 83% went on to be downgraded.[iii]
The experts at identifying default risk, the rating agencies, failed to see the runaway train barreling down the track.
The examples given here are just a few of the thousands available. The point is that you absolutely cannot rely on experts to guide your money decisions. You must develop your own systematic plan for managing your money.
Experts do provide tremendous value, however. They and their followers push the markets out of line with the reality of their true value, presenting you with trading opportunities.
We will examine why these "experts" can be so wrong in the next and final installment 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] Smith, "Bringing Down Wall Street as Ratings Let Loose Subprime Scourge."
[ii] Smith, "Bringing Down Wall Street as Ratings Let Loose Subprime Scourge."
[iii] Phil Angelides, "Opening Remarks" (statement before the Financial Crisis Inquiry Commission Hearing on the Credibility of Credit Ratings, the Investment Decisions Made Based on Those Ratings, and the Financial Crisis At The New School, New York City" June 2, 2010).
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