Let the Market Act

The woes of the subprime lending market, even the mortgage market as as whole, are much in the news still.  The Washington Post headlines a story today, regarding yesterday’s stock market drop, Stocks Fall With Lender’s Earnings, noting that the catalyst for yesterday’s drop appears mostly attributable to Countrywide Financial’s poor financial performance, which Angelo Mozilo attributed more to prime borrowers’ home equity loans, than poor subprime loan performance.  A story also reported on by the New York Times under the headline Lender Sees Mortgage Woes for ‘Good’ Risks.

The NYT also has a guest op-ed on the subject, written by Joshua Rosner, titled Stopping the Subprime Crisis.  Rosner is a managing director at the firm Graham Fisher & Company, a company which provides “independent research for institutional investors in financial service assets.”

Rosner’s op-ed for stopping the subprime “crisis” focuses on the role of credit rating agencies; Standard & Poor’s, Moody’s Investor Services, and Fitch Ratings; and he writes the following.

FOR five months, it has been clear that rising delinquencies and foreclosures, coupled with higher interest rates on adjustable mortgages and declining home price appreciation, would undermine the market for mortgage securities. Yet it took Moody’s Investors Service, Fitch Ratings and Standard & Poor’s, the three leading agencies that rate long-term debt, until this month to react to this looming financial crisis, which involves more than $1.2 trillion of subprime mortgages originated in 2005 and 2006 alone. As one investor asked during a recent S.&P. conference call, “What is it that you know today that the markets didn’t know three months ago?”

The answer to the quoted investor’s question may simply be that the over exuberance for the type of returns generated by subprime lending, coupled with the volume of loans which had until quite recently been running full speed ahead, and which are now under extreme pressure though not quite at full stop, have given cause for a more sound financial analysis of this debt.

Further into Rosner’s op-ed he chides the rating agencies for doing “too little, too late,” and states,

S.&P. has stated that it now has reason to “call into question the accuracy of some of the initial data provided to us.” This suggests that S.&P. may have chosen either to merely accept the data offered it by issuers without doing its own due diligence. Or worse, S.&P. could have ignored other information because it might have hurt revenues by reducing the number of assets it could have rated.

A statement which does not out right accuse Standard and Poor’s of fraud, but seriously questions their ethics and business acumen in their chosen field of operation.

Rosner then offers up suggestions for the rating agencies.

...require the credit rating agencies to regularly review and re-rate debt securities…Training and qualification standards for ratings analysts…to help create consistent, objective, transparent and replicable methods. Moreover, rating agencies should put in place automated and objective systems, based on the changing value of underlying assets, to continuously re-rate debt structures.

The above are sound suggestions, and the credit agencies, and the users of the credit rating agencies’ ratings, should take heed.  Unfortunately, rather than allowing the market to correct the deficiencies noted, Rosner suggests the following.

Each of these actions would serve the interest of investors large and small, public and private. Unless the government acts, the credit ratings agencies will stand on the sidelines of the coming crisis, doing nothing until it’s already happened.

I refer Rosner to Dr. John R. Lott’s Jr. book Freedomnomics.  Specifically Chapter 3, Government as Nirvana?, from which I quote the opening paragraph, on page 83.

People frequently call for government intervention in the economy whenever the market is believed to be acting imperfectly.  Implicitly, the comparison is between the flawed way the market actually works on the one hand, and a nirvana-like state of government-run perfection on the other.  Do distortions ever develop in a free market?  Of course they do.  Few people would argue the market is flawless.  But it’s a long leap from showing that such imperfections exist to proving that they would be solved or even mitigated by government intervention.  In fact, government intrusion in the economy tends to result in more inefficiency, unfairness, and even predation than we would find in a completely free market.

I recommend Mr. Rosner read Dr. Lott’s entire book, as a research project.

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