Those that oppose it warn that it will lead to another financial crisis.  On that note, I want to revisit my take from earlier this year on the cause of the crisis that almost destroyed the global economy.

“With all of the complexities of the housing bubble and the subsequent global financial crisis, it can seem like a web of deceit.  But it all boils down to one simple actor.  It wasn’t Wall Street.  It wasn’t hedge funds.  It wasn’t mortgage brokers.  These entities were operating, in large part, from the natural force of economics: incentives. 

It wasn’t even the government’s initiative to promote home ownership that led to the proliferation of mortgages being given to those that couldn’t afford them.

So who was the culprit?  

It was the ratings agencies. 

Housing prices were driven sky high by the availability of mortgages. Mortgages were made easily available because the demand to invest in mortgages, to fund those mortgages, was sky high.  

But what drove that demand to such high levels?  

When the mortgages were combined together in a package (securitized as a mix of good mortgages, and a lot of bad/higher yielding mortgages), they were bought, hand over fist, by the massive multi-trillion dollar pension industry, banks and insurance companies.  Yes, the guys that are managing your pension funds, deposit accounts and insurance policies were gobbling up these mortgage securities as fast as they could, but ONLY because the ratings agencies were stamping them all with a top AAA rating.  Who would encourage such a thing?  Congress.  In 1984 they passed a law making it okay for banks, pension funds and insurance companies to buy/treat high rated secondary mortgages like they would U.S. Treasuries.

So as investment managers, in the business of building the best performing risk-adjusted portfolio possible, and in direct competition with their peers, they couldn’t afford NOT to buy these securities.  They came with the safest ratings, and with juicy returns. If you don’t buy these, you’re fired. 

To put it all very simply, if these securities were not AAA rated, the pension funds would not have touched them (certainly not to the extent). With that, if the there’s no appetite to fund the mortgages (no money chasing it), then the ultra-easy lending practices never happen, and housing prices never skyrocket on unwarranted and unsustainable demand. The housing bubble doesn’t build, doesn’t bust, and the financial crisis doesn’t happen. 

That begs the question: Why did the ratings agencies give a top rating to a security that should have received a lower rating, if not much lower?  

First, it’s important to understand that the ratings agencies get paid on the products they rate BY the institutions that create them.  That’s right. That’s their revenue model.  And only a group of these agencies are endorsed by the government, so that, in many cases, regulatory compliance on a financial product requires a rating from one of these endorsed agencies.”

Keep this in mind as the fear mongering over the talk of repeal of rework of Dodd Frank heats up.

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