Diagnosing Capitalism's '08 Melt-Down

Capitalism's 2008 Melt-down:
Fundamental Flaw, or Defective $5 Part?

The "who-dunnit" sweepstakes are on.

According to heavyweights such as economist Joseph Stiglitz, the 2008 Market Melt-Down is due to multiple, systemic problems in modern capitalism (if not society in general) that date back decades. Others go even further, arguing that capitalism itself is fundamentally flawed, and that its current problems are both inevitable and insoluble.

However, what if the global financial melt-down can be traced to the failure of a mundane, $5 part? If true, instead of completely overhauling capitalism -- or abandoning it altogether -- then all it would need is a tweak.

In fact, the latter scenario is the more plausible one.

If 2008 Wall Street is the financial equivalent of the Challenger space shuttle explosion -- an analogy that looks more apt by the day -- the "O-ring" was a credit ratings failure on a massive scale. That places the $5 billion a year credit rating business -- the equivalent of a $5 part in today's multi-trillion, global economy -- at the epicenter of today's financial storm.

Consider:

--Without Triple-A ratings on trillions in mortgage-backed securities, global banks and investors wouldn't have been willing to buy them.
--With no ready demand for its securitized loans, Wall Street wouldn't have started shoveling money into the housing market.
--Without Wall Street-fueled demand, housing prices wouldn't have begun to levitate.
--Without rising home prices, millions of marginal borrowers, using very marginal loans, wouldn't have piled into the market seeking easy riches (this was the penultimate and most damaging phase of the housing bubble).
--Without millions of toxic loans . . . there would have been no carnage once housing prices inevitably stopped rising (indeed, they never would have taken off in the first place).

Enron Cubed

Were there other, contributing factors? Absolutely.

Investment banks, with a pass from the SEC and other regulators, leveraged their bets by 30:1, 40:1 -- or more. To reduce these outsize risks, Wall Street conjured up credit derivatives, transforming a financial house of cards into something bigger and worse: an insured financial house of cards (thank you, AIG).

Democrats in Congress clearly pressured Fannie Mae and Freddie Mac to relax credit standards to marginal borrowers. Alan Greenspan dropped rates too low, and kept them there too long. Predatory lenders put millions of vulnerable borrowers into toxic mortgages with built-in detonators.

There's more . . .

Absurd (and obscene) compensation and government-insured losses made the rewards irresistible, and the risks irrelevant. Notwithstanding Enron and Sarbanes-Oxley, lax accounting standards permitted financial institutions to hide hundreds of billions in liabilities from shareholders in invisible, off-balance sheet accounts.

And still . . . none of these factors, in and of themselves, could have given rise to the astounding global credit and housing bubble now unwinding, with a vengeance. The alchemy by which Wall Street transformed the Fed's free, short-term money into high-yielding, long-term "assets" was the credit-rating imprimatur attached to securitized debt. Wash, rinse, repeat -- times trillions.

Capital Offense(s)

So just how culpable are Standard & Poor's, Moody's, and Fitch, the so-called nationally recognized statistical rating agencies ("NRSRO's") that dominate the credit rating business?

The short answer: somewhere between Morton Thiokol-culpable and Arthur Andersen-culpable (the former designed and built the shuttle "O-ring"; the latter audited Enron's books).

Like Enron, the question these companies must ultimately answer -- presumably as defendants at trial -- is whether they knew, or should have known, that the ocean of debt they blessed was doomed.

In legal terms, did they have the requisite "mens rea" (guilty mind)? If they did, they committed fraud; if they didn't, they're guilty of gross negligence.

Some Henry Blodgett-style internal emails strongly suggest the former, i.e., the credit agencies suspected their ratings were dubious, or at the very least, ill-informed guesswork. (Just as a refresher, Blodgett was the Merrill Lynch analyst tossed out of the securities business for recommending Internet stocks while privately trashing them.)

Even if they didn't know, that leaves whether they should have.

They certainly were paid to have known. In addition to rating debt-backed securities, S&P, Moody's, & Fitch made even bigger money designing them.

Of course, in both cases, payment came from the very entities whose product(s) were being rated. Just like Arthur Andersen at Enron, that conflict of interest alone was enough to compromise the rating agencies' independence and integrity -- and arguably did.

Financial Crimes & Punishment

So what punishment fits the credit rating agencies' crime?

The damages attributable to their conduct -- whether willful or negligent -- are staggering.

Whereas Enron cost investors, creditors, and employees perhaps $100 billion, the cost to taxpayers just so far for the various Fed and Treasury bailouts, guarantees, and loan facilities now potentially exceeds $8 trillion. As bloggers like Barry Ritholtz note, that's the biggest bill footed by the U.S. government, for anything, ever -- including World War II. To the extent that U.S.-style capitalism has suffered long-term, systemic damage, the real cost is incalculably higher.

In retrospect, meting out capital punishment to Enron's aider and abettor, Arthur Andersen, seems a bit draconian.

Given the organization's balkanized structure, it really was collective -- and therefore unjust -- punishment to hold Andersen partners in Atlanta, Denver, and Spokane and elsewhere accountable for the sins of their Houston brethren -- sins they likely knew nothing about. For another, the lucre that Arthur Andersen made off with was peanuts in comparison to what Enron management raked in.

Arthur Andersen Died for Less

So why have the credit rating agencies yet to receive so much as a jaywalking ticket??

The best answer may be that it's simply too soon. After all, it's hard to do financial forensics analysis while the crash debris is still smoking.

With Fed-set interest rates at zero and credit still frozen, it's far from clear that the financial melt-down isn't still ongoing. Until that's apparent, the attention and resources of all key players necessarily remain focused on limiting the damage to financial markets and the broader economy, then gradually nursing them back to health.

Eventually, however, the time for assigning responsibility and avoiding future melt-down's will be at hand.

The good news about a small part being the likely culprit is that the fix need not be exorbitantly expensive, require protracted national soul-searching, etc. (The cost of the clean-up is another matter altogether.)

The bad news is, at the moment, there's no backup vehicle.