It's the process ... not the rating agencies!

Today, the Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises heard the testimony of Sean Mathis on the "The Role of Credit Rating Agencies in the Structured Finance Market." The hearing was meant to review the role of rating agencies (Nationally Recognized Statistical Rating Organizations - NRSROs) in developing debt products. The inherent conflict of interest among rating agencies, issuers and the investment banking industry should come as no surprise - especially when you consider the market processes and the flow of capital. As such the rapid introduction of new financial instruments and the intentions to maximize profits regardless has permeated every aspect of the credit cycle. Ultimately, you can't get something for nothing - eventual someone will pay.

The engineers behind the current mortgage market crisis are no different than any other time when the market saw such a swing. Overconfidence, rising asset values and growing leverage throughout the whole financing cycle is evident, but the music has stopped or at least changed.

When market participants placed more trust in yesterday's strategies -gains became more important than the underlying processes of the business. Congress must get back to basics and recognize the importance of housing as a means to financial stability for all market participants. What we see now is long term funding commitments giving way to investor needs for safety and gains. Basic fears across the market cycle have been fueled by greed.

The rush to exit the markets by investors once the music stopped was inevitable -- look at the past 20 years of financial crises. The rating agencies did not have a crystal ball, but they did have the responsibility to pose the questions needed to assess risk. But like all cycles and crises before this one, exuberance and greed clouded the ability to make prudent decisions and recommendations while regulators around the world have been asleep at the wheel.

To question how the credit quality of complex financial instruments is assessed serves what purpose? Yes the recent decisions by NRSROs to downgrade the ratings of many residential mortgage-backed securities and collateralized debt obligations in the wake of the recent global credit crunch is questionable but the real question that Congress needs to ask is, “What and where are our trusted institutions in the market cycle for housing finance?”

According to Mathis, "The pain that will be suffered from the collapses across the structured finance landscape will not merely be born by well-healed fund managers or greedy, intemperate citizens looking to make a fast trade in a frothy housing market. The pain will be felt as well by regular people whose pension funds have been impaired by investment in gold-plated highly rated securities whose performance will turn out to be far worse than the promise implied by their ratings,"

Mathis also stressed that Congress, it must act to address a number of critical and complex issues.

1. Regulatory oversight and supervision of the rating agencies (NRSROs). While this is in fact needed, it does not get to the systemic imbalances that exist in housing finance.

2. Applicability of NRSRO ratings. This is a moot point. Ask most investment bankers about the new BMW 760Lsi. It is rated to go top speed at 150mph, but is it appropriate to drive that fast?

The growth of subprime and subprime linked securities was inevitable when we lost sight of meaning of home and housing.

3. Compensation-driven conflicts of interest. With investment bankers realizing on average over $1,200 per mortgage underlying the mortgage finance instruments of recent years, it is pointless to assess the compensation-driven conflicts of interest at one point of the market cycle. Again the question that remains, “What and where are the trusted-institutions?”

Rating agencies have been expected to assess risk, and they have. But the real risk moves across the market process and pose different consequences to wide array of market participants. As such, it has become extremely difficult to link a prospective investor in mortgage securities with the mortgage instruments intended to finance housing transactions.

4. Accountability. Like liquidity, accountability is a fluid concept. Again the question that remains, “What and where are the trusted-institutions?” If Congress wishes to remedy the defects that contributed to the near meltdown of our financial markets, it must comprehend just how important housing finance is to our society and who bears the risks and costs associated with vehicles used to speed through our financial infrastructure which is not designed to handle them.

The role for public authorities in supporting the flow of credit to the housing sector has been critial throughout our recent hstory. The lesson learned during the S&L crisis was that it was catastrophic to finance home ownership through insured banking institutions that borrowed short term and then offered long-term fixed-rate home mortgages. Now a system reliant on securitisation, adjustable rate mortgages and non-insured financial institutions has broken down.

The only way out of this current tailspin is innovation. Long-term success for housing finance requires more innovation throughout the market process. It requires market participants to develop strategies around disruptive innovations. It is through disruptive innovations that transcend the market processes that we will create new markets or reshape existing markets by delivering relatively simple, convenient, low-cost innovations to a set of customers who are ignored by industry leaders expected to serve the common good. Who should bear the responsibility for the cost of a house? Who should determine the value of home?