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April 06, 2008

How do you explain the subprime mess to grandma?

Confused about how subprime mortgages, credit rating agencies, monolines, hedge funds, securitization, CDOs, credit default swaps and other derivatives interacted to produce the mess we are in? You are not alone. Here is an account by the Comptroller of the Currency which I found particularly useful.

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Some fifteen years ago in Basel bank regulators fed up with having to work on banking crisis came up with the idea that these could be avoided if banks put up capital in accordance to the default risk of each credit; the so called minimum capital requirements for banks.

Now, since no one would ever trust some bureaucrats with measuring the credits, they outsourced that responsibility to the credit rating agencies and sold the idea that the market was fully at work.

Little by little, having been appointed by the regulators and having all the banks following their criteria, the credit rating agencies developed an aura of invincibility; that was not even tarnished by cases like Parmalat, Enron and Argentina since two of them were fraudulent cases and the other just Argentinean.

Banks started to dismiss credit analyst in banks since “why bother when we still have to obey their criteria”; and financial entrepreneurs argued themselves into some very good ratings on some paper they developed, since what real opposition can a little credit rating officer give some real entrepreneurs.

And so the credit rating agencies, like the Pipers of Hamelin, one day led the investors over a precipice, in this case the subprime mortgage precipice.

And now everyone wonders whether we are going to quit using the credit rating agencies or whether we are going to insist on going over an even larger precipice in the future, just because some bank regulators cannot admit they were stupidly wrong.

Perhaps not all grandmothers do understand my explanation, but I bet many of them intuitively understand the foolishness of following just a few.

And by the way are there not many more risks for the society related to the financial sector than their possible default and crisis? Where banks not also supposed to help development and growth…at least that is what they told us when we were young.

Now you can discuss this back and forth but the only real unavoidable fact that stands out is that the securities collateralized by truly junky subprime mortgages would have traveled nowhere, had it not been for the prime wings furnished to them by the credit rating agencies.