"In my view, the credit issues aren't just about subprime. Subprime is what the media says. Subprime is what parts of our financial establishment say. Subprime is about them-- those people and the people who made foolish loans to them. The word "subprime" is pejorative. Subprime is not about us, for we are not subprime. How convenient to be able to pass the blame."
This remarkable outburst is from a speech given by hedge fund manager David Einhorn on Oct. 19, brought to our attention by Naked Capitalism's Yves Smith.
Einhorn's central point is that the problems afflicting financial institutions across the world today shouldn't be blamed on the dreaded taint of "subprime contagion." Unscrupulous mortgage lenders didn't screw up the fun for everybody else. Instead, exactly the same mistakes that were made in the subprime lending sector were being made at every level in the game: Money was being lent willy-nilly without a proper appreciation of the underlying risk. This was just as true for the lenders pouring cash into commercial real estate like malls and factory buildings as it was for residential homes. And just as true for the big Wall Street players selling each other all those fancy derivatives. The mortgage brokers who offered no-money-down loans to customers with no documentation of income were offering the same kind of deals as the banks who lent billions to private equity funds to pay for their leveraged buyouts. "There has been a colossal undercharging for credit across the board," said Einhorn.
Nowhere was this more true than in the exotic land of complex financial derivatives such as collateralized debt obligations (CDOs). This is territory that the financial press has explored obsessively since mid-August. We've learned a lot about what happened, but what's less clear has been how to fix it so it won't happen again.
One remedy that is often proposed is the magic incantation of "transparency." If we knew more about the details of how these financial instruments were constructed we would be better able to understand their riskiness.
How the World Works has always had trouble translating the invocation for greater "transparency" into practical detail. What, exactly, we've been wondering, could government mandate that would bring some more clarity to this mess?
Einhorn offers an easily understood first step. The rating agencies -- Moody's, Standard & Poor's, Fitch -- have come under sustained criticism for their role in the credit crunch. The triple-A ratings that they plastered all over the billions of dollars' worth of derivatives that turned overnight into toxic waste were obviously unmerited. What I didn't understand until reading Einhorn's speech, however, was that the ratings agencies base their ratings on proprietary information about how CDOs and the like were constructed that the underwriters of those instruments did not disclose to anyone else.
"Why would anyone blindly lend to an opaque structure full of loans or pieces of pools of loans that they didn't underwrite or even evaluate? Because the structures come with credit ratings form Standard & Poor's, Moody's and Fitch. Have the rating agencies developed an expertise in analyzing these structures? Perhaps, but more pertinent, they are the only ones who can evaluate them, because they are the only ones with the detailed information about the structures. The underwriters give the rating agencies much more information than is contained in the prospectus. In their evaluation of corporate credits, rating agencies are exempt from regulation FD. This meant that they can receive confidential information not available to other market participants. This is kind of like a confessional where the priest delivers a public opinion on the extent of your virtues or sins -- and your spouse has to guess what AAA or BBB means about your fidelity."
(Regulation FD (for "fair disclosure") is an SEC rule enacted in 2000 requiring that a public company disclose to the general public any relevant information that it has disclosed to anyone else outside the company.)
"One clear improvement to the current structure of the debt markets would be to insist that all information shared with rating agencies be shared with the whole market; the rating agencies should lose their exemption from Regulation FD. When Regulation FD was implemented many worried that if equity analysts didn't have special access, the stock markets would become less stable. That hasn't proved out. The credit markets should take the same step. More information broadly disseminated makes for a more efficient market."
If we don't take that step, we will, in effect, be conceding that we are all subprime.