How is it that assets built out of mortgages which just yesterday were worth so much are worth so little today? Investors have only recently come to realize that the ratings for these assets were terribly biased. The question now is why we ever came to believe mortgage-backed securities were worth our investing dollars in the first place. There is of course much blame to go around. But insufficient attention has been paid to how ordinary investors-not greedy capitalists but instead those of us who are trying to save for our retirement, our kids’ college education, or, indeed, the down payment for a house!-trusted the experts and got burned.
Experts are constantly telling investors what to buy. Sometimes they give us good advice and sometimes not. So surely the fact that there are experts who give investment advice can’t explain the trillion-dollar bubble and subsequent meltdown we’re now witnessing. The key additional fact is that experts were selling advice about mortgage-backed assets as if those assets were independent when, in reality, they weren’t at all independent assets. Only once investors realized that the housing market is a national market-not a local one-did it become clear that these securities were extraordinarily risky. Hence the collapse.
Until very recently it was widely believed that all housing markets were local. If this were so, then assets constructed by pooling mortgages across different localities would consist of pooled independent assets. And these new assets would be dramatically less risky to hold than a single mortgage of similar worth: Combine a bunch of diverse mortgages and sell shares of the new security and those shares represent much less risk than holding a single mortgage of the same value as the share. Or so the story went.
All of this, however, depended critically on housing markets being local, so that the assets in the pooled security didn’t move together. Not so long ago, this was the conventional wisdom. Federal Reserve Chairman Alan Greenspan testified to this effect before Congress in 2005, when the housing bubble was well under way: “The housing market in the United States is quite heterogeneous, and it does not have the capacity to move excesses easily from one area to another. Instead, we have a collection of only loosely connected local markets.”
So, following Greenspan’s advice, a firm could build highly rated investment portfolios of purportedly uncorrelated assets out of nothing but mortgages from different parts of the country. Once these portfolios were built, it would become easier to finance houses even for buyers of dubious credit. The problem was that these new securities, and the money which flowed into all housing markets, were sufficient to generate correlation in housing values across the country. As everyone followed the experts’ advice-and invested in these new mortgage-backed assets-we began to observe correlated behavior in the housing market, nationwide.
So how did the securities maintain their high investment grades? Once correlations were evident, once the interconnectedness of housing markets nationwide was evident, why didn’t another set of experts, the rating agencies, step in and downgrade the securities?
Because of incentives, the cornerstone of economists’ advice about how to get good economic outcomes. In this case, the incentives weren’t there to obtaining unbiased estimates of security values. Instead, incentives favored “rating shopping” and so, unsurprisingly, rating shopping became the norm. The Securities and Exchange Commission’s 1994 report, Concept Release: The Nationally Recognized Statistical Ratings Organization (NRSRO), contained the following sentences:”A mortgage related security must, among other things, be rated in one of the two highest rating categories by at least one NRSRO.” The phrase “one of the two highest rating categories” authorized the firm holding a mortgage backed security to shop for ratings. If one rating agency failed to produce a desirable rating, the firm could look for another, more favorable rating.
Those who made the ratings became like expert witnesses in court, seeing things the way their clients, the firms holding the securities and offering them for sale to you and me, wanted things to be seen. The problem was that shoppers, like a jury, did not have the ability to average out different pieces of testimony to help remove the bias. As long as experts were trusted and the market didn’t know the difference between unbiased and biased estimates, the trick worked marvelously. The collapse followed suddenly as we have all come to understand that the ratings were miserably biased.
All of this is a telling lesson about how much and when to trust the experts. This is especially so now that a new set of experts is attempting to get us all out of the mess we’re in.
David M. Levy is an economist at George Mason University and Sandra J. Peart is an economist at University of Richmond. They are the authors of The Vanity of the Philosopher: From Equality to Hierarchy in Post-Classical Economics. This column first appeared at Reason.com.