Credit and Blame

I recently read a Wall Street Journal article from 2007 for my Econ 211 class that offers an interesting scope into the years leading up to the Great Panic of 2008.  The article describes how rating firms like Standard and Poor’s, Moody’s Investors Service, and Fitch Ratings catalyzed the subprime mortgage crisis of the early 2000s. During this boom in sub-prime mortgages, as we learned in class a few weeks ago, borrowers with weak credit were able to take a “piggyback” loan or a secondary loan to help pay for the down payment of the mortgage.  Underwriters then assembled these extremely risky loans into securities which were sliced into “tranches,” with the riskiest of tranches having the highest level of return.  As we know, during this time, the Fed  was keeping interest rates low; so many investors were in search for these high-risk/high-return securities.  When housing prices finally fell, and the sub-prime mortgage bubble burst, many were left wondering how the tranches containing the extremely risky sub-prime mortgage bonds received such good ratings.  The reason lies within the role of the rating firms in the sub-prime market.  Rating firms receive fees about twice as high when they rate securities containing a pool of home loans.  If underwriters didn’t receive a good enough rating for their tranches of securities, they would take their business to a rating company that would give them a better rating.  They called it "best execution" or "maximizing value," but in reality they were shopping around for a good deal on a fabricated rating.  As a result, some of riskiest tranches were given triple-A ratings, and because many hedge funds and money managers relied on these ratings, they bought securities in large quantities.  Enter a sudden and unexpected rise in housing prices, and you know the drill.  

After reading this article, I am a bit more reluctant to point the blame at the Alan Greenspan and the Fed for the monetary policy they enacted during this time.  Their policy was merely a groundwork that would provide for honest economic growth, but unfortunately would be taken advantage of by a culture of greed on Wall Street.  Shady backdoor deals between underwriters and executives at ratings firms are just one of the many components that caused the Great Panic of 2008.  If we experience a promising economic environment again in the future, hopefully the volatile actors of Wall Street won't be overcome by a voracity for personal profit, and realize the risk involved in the decisions they make.