The cause of the crisis 4-3

In the cause of the crisis, I addressed fraudulent ratings.

Bill draws my attention to a report on securitized loans issued by the New York Fed in which they examine the somewhat surprising ratings given to New Century Financial:

You might consider blogging this absolutely hilarious paper from a couple of people at the New York Fed. The good stuff starts on page 14, where we learn about a typical pool of securitized mortgages originated by New Century Financial. There were about 3900 mortgages in the pool (made in 2006), and the pool had the following characteristics:

• more than half are cash-out loans
• 83% have FICO scores below 660
• average (average!!) total debt service to income is 41%
• 88% are hybrid ARMs with payment adjustment in 2-3 years
• typical adjustment 25 to 40 % increase in payment
• adjustment is bigger if rates rise
• half (!!!) the loans are “stated income,” i.e. liar loans

Page 15 tells us that of the Alt A loans in the New Century pool in 2006, five out of six were “low doc” (liar) loans, and two out of five had additional silent mortgages – that is to say, not only was the borrower income not truthfully revealed, but the extent to which the property was likely to be underwater not truthfully revealed.

Incredibly, 79% of the tranches in this dog were rated (by both Moody’s and S&P) AAA. How are the people who asked for and gave that rating not in jail? To be clear, AAA means really, really, US gvt treasuries safe.

Clearly, the people and institutions buying these securities were trusting the ratings agencies — nobody smart who read, digested, understood, and thought about that prospectus ever bought any of these (except as a regulatory dodge).

The conclusion of the paper is also really funny in an arch, extreme understatement kind of way.

On page 61:

Ohio Attorney General Marc Dann claims that the Ohio state pension funds have been defrauded by the rating agencies. […] To his mind, the seemingly cozy relationship between ratings agencies and investment banks like Bear Stearns only heightens the appearance of impropriety.

In this section, we review the extent to which investors rely on rating agencies, focusing on the case of this Ohio pension fund, drawing upon on public disclosures of the fund.

They then find that the Ohio pension fund invested heavily in the kind of subprime crap that they examined.

In the end they optimistically conclude:

Our view is that the rating of securities secured by subprime mortgage loans by credit rating agencies has been flawed. There is no question that there will be some painful consequences, but we think that the rating process can be fixed along the lines suggested in the text above.

No doubt it can be fixed along the lines suggested, but from the fact that the ratings agencies have not been prosecuted, and their regulators have not been fired, it seems unlikely that it will be fixed.

Attorney General Eric Holder has launched a bunch of prosecutions about mortgage fraud. It is hard to explain financial scams to twelve men too stupid to evade jury duty, but a major reason for the failure of prosecutions so far is that the Attorney General has been prosecuting minnows, the minnows blame the sharks, and were he to prosecute the sharks, the sharks would doubtless blame the regulators – who, strange to report, still have their jobs.