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Rating Agencies Did Not Understand Derivatives

One really important new revelation has come to light during the first panel of today's Financial Crisis Inquiry Commission hearing on rating agencies. People at the rating agencies did not realize that securities and derivatives were being created for the explicit purpose of failing. They slapped top ratings on many of these deals, without realizing that there were people involved in the transaction who wanted it to torpedo. Although Moody's officials didn't mention Goldman by name, this situation has a very significant bearing on the SEC's current fraud suit against Goldman Sachs-- and on our understanding of how the housing bubble inflated to such a catastrophic magnitude. Goldman created a very complex security called a synthetic CDO, in order to allow a hedge fund kingpin to bet against it. Goldman itself also bet against the security, while selling the same security to others as a safe investment. The SEC's case against Goldman is very strong, but the only reason it isn't an outright slam dunk is because Goldman maintains it was acting as a "market maker," rather than an "underwriter." When a bank underwrites securities, it is essentially creating those securities and packaging them for sale in the market as a sound investment. To bet against that security, or intentionally structure the security to lose money would be outright fraud. But market-making is different. It's the sort of thing a Las Vegas bookie does. In market-making, the bank tries to find different investors who want to bet for and against something—say, the housing market—and then serve as the means for making that bet. This is what Goldman says happened with the synthetic CDO at the heart of the SEC's case. Goldman claims that it wasn't signing off on the quality of a new security as an underwriter, it was just facilitating a bet for two different types of investors who had opposing views of a certain asset. One thought subprime mortgages were a good investment, another thought they were a bad investment, and Goldman says that its deal was just designed to allow that bet to take place, not to imply that either bet would be good. Now, there are plenty of reasons to believe that Goldman's defense is a total pack of lies, and that they were in fact acting as an underwriter. Blogger Steve Randy Waldman has the definitive account of this, and it's right:
What happened here is nothing like what a market maker does. A market maker takes the other side of client-initiated trades, and then lays off the risk. ABACUS was initiated and sold by Goldman Sachs, at a hidden party's request. Goldman was unwilling to make a market for Paulson at a price he would have accepted, so it manufactured an entity willing to do so. Investors in that entity were not informed that they were dealing with an active, involved adversary. And Goldman has the nerve to call both sides of the arrangement 'customers.'
But today's testimony from raters at Moody's indicates that the very people who were assigned to rate these deals simply did not understand them. Moody's was rating complex derivatives and securities deals without realizing that they had been designed by people who would profit from their failure. This is not just testimony from interested parties trying to cover their tails—the key witness on this matter was Eric Kolchinsky, a Moody's whistleblower who is not well-loved by the rating agency's management. This reinforces the narrative that rating agencies frequently acted as accomplices for bankers trying to pull over a major fraud on the broader economy. In this case, it indicates that rating agencies did not even realize the extent to which they were acting as accomplices—the banks had designed deals so complicated, the rating agencies couldn't even figure out what was going on. They went away and rated the deals anyway, and made a lot of money on it. It's hard to feel sorry for the rating agencies. They screwed up, both through corruption and incompetence, and yet still made money. But that fact does not excuse the wrongs committed by bigwig bankers during the crisis. In this particular case, it shows that bankers were deliberately manipulating the rating agencies in order to mislead their own clients. That's terrible in and of itself. But creating these bogus subprime securities and derivatives fueled demand for subprime mortgages, which ended up wreaking havoc on neighborhoods all over the country. That's even worse.