Mort & Hank Talk Economics #2

How Competition and the Bottom Line Can Affect Honest Reporting

I met Mort again at the coffee shop Saturday afternoon. I got there first then Mort slunk in looking so morose I wondered why he came out of his house for coffee and a Danish.

“What’s the trouble, Mort?” I said.

“Ah, Hank, times are bad, really bad. I think times are even worse than I thought before. Did you ever hear the saying, ‘the first guy lies, then the second guy swears to it?’”

“Yeah, I can remember hearing that before—it was part of the vernacular when I was growing up in the Midwest. Especially useful when guys were telling tall tales. One guy would tell a ‘huge fish that got away story’, and another feller would say, ‘Yeah, ‘at’s right—I was there too and seen it with my own eyes.’ ‘Course, they were both lying!”

“Well, I was reading a piece in the Times today, and it just about sunk me down to the scuppers. It had to do with this current financial crisis. And it made me think of that old saying.” The waitress brought us our coffee and pastries.

“How so, Mort?” We both lifted our cups and took scalding swallows. Mort blinked and shook his head and I had to squinch my eyes.

“Okay, one of the liars in this story is Standard & Poors’ credit rating organization and the other is Moody’s credit rating branch. Here’s the deal. A few years ago, Moody’s got spun off from D&B—Dun and Bradstreet. Now Dun and Bradstreet has been reporting on businesses credit ratings for oh, I dunno, a couple hundred years. Still are, I reckon. But they wanted out of the securities and bond credit rating business. So they spun Moody’s off on their own. You with me so far?” He chewed a bite of Danish.

“Yep. Now Moody’s is out there on their own, trying to make a profit, right?”

“You got it, Hank. Well, Standard and Poors practically had a monopoly on bond rating forever. So Moody’s said, “We gotta get some of that business away from S&P. How can we do it?” What they decided to do, was relax their criteria that would make what you might call marginal stuff into triple A rated stuff. Then the clients what wanted to have a triple or double A rating on securities issues, or packages of various kinds of issues had an up-to-then reliable outfit stamping out triple A ratings—those clients came on over to Moody’s. Now here’s what—for a century or two, those outfits had almost a quasi-regulatory status among investors. If one a them said something was an AAA risk, it was like the Agriculture Department putting a ‘Choice’ stamp on a piece a beef. Or calling it Kosher. It was by God practically guaranteed to be a secure risk, barring a catastrophe.” He took a swallow of coffee.

“Okay, so then Moody’s started eating into Standard and Poors’ share of the market, huh?” I said and finished off the last bite of my Danish.

“Yep, that’s it. So do you wanna guess what S&P did then?”

“Let me try. They followed suit and relaxed their criteria, too—right?”

“On the nailhead, Hank. So now you’ve got these two old companies that’ve built a reputation over a century or two, each trying to keep a-hold of their share of the market. And what do you think came along as these two were competing head-to-head in the earlier part of this decade?”

“I dunno, Mort. Something to do with the housing bubble and subprime loans, I bet.”

“Right again.” Mort swallowed down the last sip of his coffee and signaled the waitress for a refill. “The mortgage guys and the Wall Street guys came up with this instrument called a CDO—collateralized debt obligations. What those were was bundled-up bunches of mortgages—some of ‘em good and some of ‘em those damn’ subprimes.”

“Uh-oh, trouble,” I said.

“Big trouble. What they were doing was rating those CDO’s based on the good loans in the package and ignoring the bad ones when they rated ‘em.” Mort frowned. “Credit analysts from both companies, some of ‘em with forty years experience, were jumpin’ like rats off a sinking ship. And some of the managers and executives, too. They’re out there saying, ‘Top management wants us to rate this garbage way too high. I ain’t gonna stand by and see this happen.’ So a bunch of ‘em quit or took early retirement if they didn’t wanta play along. So Moody’s was rating some junk too high, and then S&P was backin’ ‘em up—or vice-versa. Either way, one was lying and the other was swearing to it. It was like they broke a sacred trust.” Mort swallowed up the rest of his coffee.

“Holy smoke,” I said. “Those companies gotta have analysts, don’t they?”

“Well, sort of, Hank. There’s a new breed o’ cat out there called ‘quantitative analysts’ that build an analysis on computer models. Only they seemed to leave historical per-formance data out of their models. At least that’s what some old-timers said. Their models sorta made it look like nobody would get hurt too bad.”

The waitress looked at us like she was gonna start charging us rent for our table.

We left a dollar apiece on the table for a tip and walked to the cashier desk to pay our checks.

As we walked toward our cars, I said, “Well, thanks, Mort. Talking to you doesn’t make me feel any better, but it usually makes me feel smarter.”

Mort gave me a weak wave before he got into his car and drove off.