Friday, 19 December 2008

When something doesn't work use more of the same

It's almost a law of governments - if something you are doing doesn't work don't change it just do more of it. We see this principle regularly applied in various attempts at social engineering and now I  notice it has spread to economics.

One of the necessary first steps in the global financial crisis was a slavish belief in those strange institutions called ratings agencies who charge those wanting to borrow money to obtain a credit rating. To get the fee for doing the work the ratings agency first has to be chosen by the borrower. Human nature being what it is, borrowers look for an agency that will give them the highest possible rating so the interest they have to pay is as little as possible. The temptation for the ratings agency to be generous in its assessment is considerable for if they don't get the job they don't get the fee.

So it came to pass that all those collateralised debt obligations or whatever they are called, ended up changing from sub-prime mortgages made to people buying houses they could not afford into triple A rated securities. It turned out to be a con on a major scale with ratings agencies nothing more than negligent money grabbers determined to get in for a share of the ill gotten gains.

To save financial institutions from collapse the American Treasury had to come to the rescue and take over billions of dollars worth of dud paper. But how to work out how much to pay banks to rescue them from their mistakes? Why, trot along to those very same ratings agencies of course and pay them a fee to value it for you.

The Bloomberg news agency gave US taxpayers this good news this morning. Federal Reserve Chairman Ben S. Bernanke, it said, is basing hundreds of billions in emergency lending on credit ratings from companies that gave AAA grades to toxic securities.

The Fed has purchased $308.5 billion in commercial paper and lent $631.8 billion under eight credit programs, most of which require appraisals of short-term debt and loan collateral by “major nationally recognized statistical ratings organizations.” That, in effect, means Moody’s Investors Service, Standard & Poor’s and Fitch Ratings.

It is foolhardy to rely on the three New York-based companies, said Keith Allman, chief executive officer of Enstruct Corp., which trains investors in financial modeling and asset valuation. The major raters issued top marks to $3.2 trillion in subprime mortgage-backed securities at the root of the financial crisis.

“They’re outsourcing the credit assessment to a group of people whose recent performance has been unbelievably bad,” said Allman, the New York-based author of three books on structured finance and a former vice president in Citigroup Inc.’s securitized markets unit. “If their goal is to not take a loss on these assets, they should be hiring independent analysts.”

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