Housing Bubble: Same People, Same Rules, Different Outcome?

All eyes are on Washington this week.

The Federal Reserve is issuing bundles of new regulations for credit card issuers. There will be no credit cards for anyone under the age of 21 without parental consent or without proof of income. And there won’t be higher interest rates for higher risk borrowers.

Although those policy changes will have consequences (think college kids were broke before, looks like a boom is coming in ramen noodles), the much bigger, near-term impact on the banking system will come from the Securities and Exchange Commission (SEC). They’re going to “fix” the credit rating agencies in the name of “preventing” another mortgage security meltdown.

The New York Times reports New SEC Rule Heightens Risk of Insider Trading:

At the heart of the problem is that it is legal for companies and other issuers of securities to give confidential information to rating agencies.

Back before the crisis, the fact the agencies had access to such information served to enhance the respect given to their opinions.

Now we know that the major rating agencies — Standard & Poor’s, Moody’s and Fitch — disgraced themselves in rating structured finance products. They relied on bad assumptions, and in some cases may have been lied to by issuers. Their models turned out to be spectacularly wrong.

A lot of people think a root cause of the problem was the conflict of interest created by the fact the agencies were paid by the creators of those products, and therefore were dependent on their good will for additional business.

But regulators are unwilling to outlaw the old system, in part because that would leave investors without access to ratings unless they paid for them. So the solution chosen by the S.E.C. is to encourage other rating agencies to rate the products.

As with most issues, the Times gets the facts right, but draws the absolutely wrong conclusions.

Facts:

- Heart of the problem - agencies had access to inside information which implied their opinion was more reliable
- Regulators unwilling to make sufficient changes
- root cause of the problem was the conflict of interest created by the fact the agencies were paid by the creators of those products

Times Conclusion:

Cut off the inside information. The rating agencies now have an exemption from the S.E.C.’s Regulation FD, for fair disclosure. If that exemption were removed, the level playing field would be restored. And the respect that ratings now get from people who assume the raters know more than they do would fade away.

Real Solution:

Get rid of all government involvement in the rating agencies and let investors’ go in and rate the debt. The rating agencies have no “skin in the game” and you’ll get the similar results as any other situation where there is no vested interest in the outcome.

I see a very similar set-up in the financial publishing industry. There are two kinds of researchers.

Some are paid for by public companies. The writers, editors, or analysts are paid by the company. All that I’ve seen have fairly lengthy disclaimers, so it appears to be all legal. However, investors who don’t read all the fine print may not be aware of the obvious biases.

Other publishers of investment ideas and investment research, like us at Q1 Publishing, are independent. We work for our readers. Our interests are squarely aligned.

That kind of simple rationale could easily be applied to all of the rating agencies and the debt.

Think of it like this. Let’s say you go into a bank for a loan which you know you can’t afford and a lot of stuff has to come together for you to pay it off. You’re a risky customer. But hey, you brought your own loan officer to approve your loan. How many banks do you think would last?

The fact that if people don’t learn from the lessons of history, they are doomed to repeat it is true, we can start counting down the days until next debt-fueled bubble forms.