By Andrew L. Jaffee

How many times are we going to go through this? This time: a real estate bubble; last time: a stock bubble. Our financial markets are supposed to be transparent. And they are… generally. Most of the time, all the information is out there, but some information is more easily accessed than other information, and investors make certain assumptions about the quality of the information. Many investors depend on financial ratings services. Standard & Poor’s, Moody’s, and Fitch Ratings are supposed to investigate and assess the risk/reward of investing in companies’ stocks, bonds, and other types of securities.

But it turns out that the ratings firms had the same type of incestuous relationships with lenders as did the investment banks with the crappy dot-com companies of the 1990s. This time around, it is banks, investors, and would-be, sub-prime homeowners that will end up losing up to $150 billion — and that number may grow. Note that there is no excuse, as home buyers with bad credit shouldn’t have been borrowing, lenders shouldn’t have been lending to people with bad credit, and the ratings services shouldn’t have been putting lipstick on risky mortgage-backed securities so brokers could hock them to unwary investors. But the concept of systemic transparency (openness, truthfulness) has again taken a back seat to greed. Here’s how the real estate shell-game worked:

…While out-of-date banking regulations and lax federal oversight didn’t help matters, it was the complicity of the rating agencies — Standard & Poor’s, Moody’s, and Fitch Ratings — that enabled the boom. …

Here’s how it worked. After buyers with less than stellar credit were approved for a mortgage, lenders would bundle a bunch of iffy loans and sell them to investment banks, which would repackage these into Franken-loans and sell them to investors.

By working hand-in-glove with the rating agencies — which were paid large fees for their involvement — institutions managed to get masses of these mortgage-backed securities rated investment grade. All of a sudden risky consumer loans were reconstituted into — presto! — something seemingly no more risky than a government Treasury bond.

The whole concept, says hedge fund manager Bill Laggner, is “lunacy.” Michael Burry, who runs hedge fund Scion Capital and was one of the first to aggressively bet against supposedly investment-grade securities based on subprime mortgages, says his thesis was that “the rating agencies were horribly wrong.” In a letter to investors he compared them to investment banks during the dot-com bubble. “They were money-grubbing and sorely in need of an ethical compass,” he wrote. …

Here’s the poor-baby, mooty-moo excuses of the ratings firms:

Even today the rating agencies have downgraded only a sliver of the securities based on subprime mortgages. All three defend their ratings, and they point out that they told investors not to rely solely on them. …

And how useful is useless information?

The bigger question may be an existential one. Asks Jim Chanos, the head of Kynikos Associates, which has a short position in Moody’s stock: “If the rating agencies will downgrade only when we can all see the losses, then why do we need the rating agencies?”

Short position or not, Mr. Chanos has a a valid point.

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Related: Economy, Corruption

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