The subprime mortgage meltdown and the ancillary predictions about whether it will drag the economy directly into a recession are headline news. But I’m losing sleep over a very different concern: What if there’s no recession because the rating agencies don’t tell the truth?
The emblem of the subprime mortgage meltdown has been Liar’s Loans–high-interest mortgage loans for which the borrowers could fill in any numbers, and the mortgage companies wouldn’t check. In other words, bad information. Now, from Gretchen Morgenson at the New York Times, comes a paragraph that makes me wonder if Liar’s Ratings are coming next:
Nevertheless, some investors wonder whether the rating agencies have the stomach to downgrade these securities because of the selling stampede that would follow. Many mortgage buyers cannot hold securities that are rated below investment grade â insurance companies are an example. So if the securities were downgraded, forced selling would ensue, further pressuring an already beleaguered market.
I get the part about the stampede, but I’m enough of a market purist to believe that when quality fails, the rating agencies MUST downgrade. If they do not, then ratings are not giving a genuine mark of the quality of securities. At that point, all confidence in the American markets will dissolve.
A piece in the Wall Street Journal last week (no link) suggested that hedge funds that had big exposures in the subprime markets were delaying their regular reports while they went shopping for more favorable valuations of the subprime portion of their portfolios. More bad data coming up?
My friends from Japan tell me that one reason the Japanese recession of the 90s lasted so long (a decade) was that the banks were loathe to write down the value of their assets. They just kept carrying over-valued property on their books. By refusing to take the hit on bad loans, they make their own reports useless and investors stayed away. Only after they admitted the problem and wiped out some companies and investors, could they move forward again.
Good data are essential to make markets work, and ratings are the gold standard. If Morgenson is right, then we may not see a recession this spring, but the long term effects for the economy would be a disaster.
