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From Liar's Loans to Liar's Ratings?

posted by Elizabeth Warren

We're all watching the subprime mortgage meltdown and the ancillary predictions about whether it will drag the economy directly into a recession.  But I'm losing sleep over a very different concern:  What if there's no recession because the rating agencies don't tell the truth? 

The emblem of the subprime mortgage meltdown has been Liar's Loans--high-interest mortgage loans for which the borrowers could fill in any numbers, and the mortgage companies wouldn't check.  In other words, bad information.  Now, from Gretchen Morgenson at the New York Times, comes a paragraph that makes me wonder if Liar's Ratings are coming next:

Nevertheless, some investors wonder whether the rating agencies have the stomach to downgrade these securities because of the selling  stampede that would follow. Many mortgage buyers cannot hold securities that are rated below investment grade — insurance companies are an example. So if the securities were downgraded, forced selling would ensue, further pressuring an already beleaguered market.

I get the part about the stampede, but I'm enough of a market purist to believe that when quality fails, the rating agencies MUST downgrade.  If they do not, then ratings are not giving a genuine mark of the quality of securities.  At that point, all confidence in the American markets will dissolve.

A piece in the Wall Street Journal last week (no link) suggested that hedge funds that had big exposures in the subprime markets were delaying their regular reports while they went shopping for more favorable valuations of the subprime portion of their portfolios. 

My friends from Japan tell me that one reason the Japanese recession of the 90s lasted so long (a decade) was that the banks were loathe to write down the value of their assets.  They just kept carrying over-valued property on their books.  By refusing to take the hit on bad loans, they make their own reports useless and investors stayed away.  Only after they admitted the problem and wiped out some companies and investors, could they move forward again.

We have talked before on CreditSlips about the need for good data to make markets work, and ratings data are no different.  If Morgenson is right, then we may not see a recession this spring, but the long term effects would be a disaster. 


I'll take issue with you on one thing: stated-income and no-documentation loans are not subprime products. To say: "The emblem of the subprime mortgage meltdown has been Liar's Loans" is incorrect. It would be accurate to say: "The emblem of the upcoming Alt-A mortgage meltdown is the Liar's Loan."

Last year and this year, Chris Cagan, a mathematician and analyst with First American, has issued forecasts of the effects of rate reset of adjustable-rate mortgages. This year's study is embargoed until Monday. It's going to scare some people. In brief, Cagan says that the foreclosure problem will manifest itself mostly among borrowers with good credit scores (I prefer not to call them "prime") who got ARMs with teaser rates below 4 percent. These are Alt-A customers.

Yes, a foreclosure wave is hitting subprime borrowers and that wave will continue. But the Alt-A wave will be bigger.

I think Holden is right. The reason we've seen years of economic growth can be attributed to consumer leveraging - that is consumption driven by borrowing. This is not a sub-prime issue. Over the past decade, American's as a group, not just the credit-challenged have over-borrowed. This has spurred the economy, but debt-driven consumption has limits. As a class, what Holden calls the Alt-A borrowers constitute a larger part of the market than the sub-primes do.

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