I had the good fortune to rediscover a recent favorite book while driving to a client engagement last week. It was the audio version of Michael Lewis’s “The Big Short”. I had first listened to it last year and thought at the time it was about as good a read (figuratively speaking) as I’ve ever enjoyed and was happy enough that the randomizing play-all option on my MP3 player offered it up again. One of the best reasons to re-read a favorite offering is that quite often different elements jump out at you which is exactly what happened this time.
There’s a passage in the book where the author shares an important insight about how advanced industry minds couldn’t quite figure out what was actually contained within the bonds being offered related to sub-prime mortgages. Referring to an article published in Grant’s Interest Rate Observer the books tells of an analyst with remarkably impressive credentials when it came to complex formulas and analytics who couldn’t quite figure out what the bonds actually contained. If someone who should be reasonably able to figure out what’s what with such things couldn’t, how than did the various rating agencies? How did the investment firms that packaged together the various loans do so in just such a way that very smart people couldn’t figure out exactly what it contained? This is an important consideration when you step back and realize that each of these investment vehicles was purchased with a few assumptions in mind: First that a highly rated bond was properly assessed by the agency issuing the rating. And second, that these bonds were issued in reasonably good faith and not with the intent to defraud.
So why am I semi-rehashing an important part of a New York Times best seller?
Because when catching up on my industry news later that day I stumbled across the latest press release from the NCUA regarding their attempts to sue the investment firms behind the aforementioned bonds. Although I’d read their previous releases it didn’t exactly connect with me the way it did this time around. Someone was actually going after the issuers of the bonds that were really the central cause of the banking crisis. Because of the perspective afforded me via rediscovering the Michael Lewis book when combined with the NCUA press release I found myself seeing the story just a bit different.
In describing the details of the lawsuit the NCUA said that it’s “against securities firms alleging violations of federal and state securities laws and misrepresentations in the sale of hundreds of securities. Additional law suits may follow in order to recover losses from the purchase of securities that caused the failures of five, large wholesale credit unions.”
NCUA Board Chairman Debbie Matz explained that “NCUA has a responsibility to do everything in our power to seek maximum recoveries from those involved in the issuing, underwriting and sale of the faulty securities that resulted in the failures of five of the largest wholesale credit unions.” She concluded by explaining that “those who caused the problems in the wholesale credit unions should pay for the losses now being paid by retail credit unions.”
The press release further expanded on the logic behind the lawsuits: “The NCUA’s suits claim the sellers, issuers and underwriters of the questionable securities made numerous material misrepresentations in the offering documents. These misrepresentations caused the corporate credit unions that bought the notes to believe the risk of loss associated with the investment was minimal, when in fact the risk was substantial. The corporate credit unions invested in mortgage-backed securities that experienced dramatic, unprecedented declines in value, effectively rendering the institutions insolvent. These suits are the culmination of lengthy investigations into the circumstances surrounding the purchases of these securities.”
But what I don’t quite understand is why the lawsuit isn’t targeting the rating agencies who said the bonds were investment worthy. Do I think the investment houses who issued the bonds knew what they were doing? I’m about as certain of that as I can be without having been there. But that’s nothing new in a free market economy – there are plenty of people trying to sell you something based on their valuation and not yours. That’s why there are rating agencies. Their job is to assess these bonds and provide an expert determination so that the market can make informed decisions and purchases. They failed to do their job, or so it would seem to me.
It reminds me of when I bought my last house pre-collapsed bubble. The appraiser from the mortgage company parked in front of the property, took his pictures, looked up the most recent comparable sales, asked the real estate agent what the agreed upon price was and miraculously his estimated value was equal to the purchase price. He shared with my Realtor that with prices escalating so rapidly it was impossible to conduct a meaningful analysis and arrive at a proper value. Really? Why? Why couldn’t he perform the job he was being paid to do? And if he really couldn’t calculate a meaningful estimate because of dramatic and rapid changes in the market that’s what he should have reported. Instead of being the last line of defense against the insanity he became a co-conspirator and allowed the problem to further escalate.
I sincerely hope that the NCUA achieves some measure of success with their lawsuits. The one missing piece to the post-collapse puzzle for me is that I never felt that the guilty were ever truly punished. The banks that sought to make money off the investments (and probably should have known better about what they were buying) were bailed out for the most part by the government. Millions of homeowners who were sold mortgages that never made any sense in the first place were foreclosed upon. And even more millions of people were left financially devastated by the major losses to their 401k’s and investment portfolios. But the bond issuers were able to keep their profits and the rating agencies continued on their relatively merry way. That just doesn’t seem right.