Category: Barnett-Hart

I beat dead horses, don’t I? But this horse isn’t dead yet.I beat dead horses, don’t I? But this horse isn’t dead yet.

“The CDOs manufactured in 2006 and 2007 were in large part a direct manifestation of their ingredients–pools of tainted assets precariously situated atop a wave of home-price appreciation.  As investors became addicted to the higher yields of investment-grade CDOs, their rose-colored glasses focused on the AAA rating rather than the pool of shoddy subprime mortgages they were really buying.  The rating agencies put too much faith in their formulas, conveniently forgetting that a model is only as good as its inputs.  Since there was little historical data on subprime or CDO performance, especially during times of economic distress, the inputs were essentially pulled from thin air, adjusted by the underwriters to maximize their AAA allotment.  ‘Diversification’ was the magic word that could justify the inclusion of anything remotely resembling a legitimate fixed-income asset, as Wall Street and the rating agencies claimed that even the lowest quality bonds would not all default at the same time.

“However, that is exactly what happened.  The trillion-dollar CDO market, built atop a single assumption, crumbled to ruins when house prices did the impossible: they first stopped rising and then they fell.  In the end, who was hurt worst when the CDO market crashed had less to do with what they were doing than with when they were doing it.  The best predictor of banks’ write-downs was not the quality of their CDOs, but instead the amount of CDOs they issued in 2007, for very few of those CDOs would ever leave the balance sheets of their creators.  The CDO market was a game of musical chairs and the winners were those who sat down early on.  The losers were those that lived by the philosophy of Citigroup’s ex-CEO, Charles Prince, that, ‘as long as the music is playing, you’ve got to get up and dance.’  Unfortunately, certain players in the CDO market, including Merrill Lynch, Citigroup, Bear Stearns, Countrywide, S&P, and Moody’s, were having too much fun to notice when the music ended, never pausing from their CDO craze for long enough to see the warning signs develop.

“Once the conveyor belt stopped, it turned out that the hot potato, which had so efficiently been passed along the chain from mortgage broker to Wall Street and beyond, had been leaving pieces of itself along the way.  Once investors no longer wanted to buy CDOs, Wall Street Banks were left holding the excess of unsold CDOs and yet-to-be-securitized CDO assets.  And once Wall Street CDOs no longer wanted to buy subprime mortgages, mortgage originators were left holding a huge number of mortgage loans they knew had little chance of ever being repaid.  And once mortgage companies no longer wanted to originate risky mortgages, homebuyers were left holding the subprime mortgages they had planned to refinance.  And once homebuyers began to default on their mortgages in mass [sic], it became clear that the credit rating agencies had made a colossal mistake, and Moody’s, Fitch, and S&P were left holding the burden of a shattered reputation in a business built on the necessity of trust.” — Anna Katherine Barnett-Hart, “The Story of the CDO Market Meltdown: An Empirical Analysis” (emphases in the original)

Close your eyes and that’ll look about rightClose your eyes and that’ll look about right

“Not only did the rating agencies fail to examine the accuracy of their own prior collateral ratings, but in many cases, they also used other agency’s ratings without checking for accuracy.  To correct for any shortcomings in the other agency’s rating methodology, they created the practice of ‘notching,’ whereby they would simply decrease the ratings of any collateral security that they did not rate by one notch.  In other words, if Moody’s rated a CDO that was composed of collateral rated BB+ by Fitch only, Moody’s would instead use a rating of BB in their own CDO model because it was not their rating.  They never went back and reanalyzed the other rating agency’s rating, conveniently assuming that decreasing it by a notch would compensate for any shortcomings in the initial risk analysis.” — Anna Katherine Barnett-Hart, “The Story of the CDO Market Meltdown: An Empirical Analysis” (footnotes omitted; emphasis in original)