Misplaced Incentives Were the Rot at the Core of the Financial Crisis

The financial meltdown whose effects continue to haunt our economy sprang from a mortgage-backed securities business ecosystem that was designed with incentives for growth at the expense of investor capital preservation. Monday's New York Times reports that an independent assessment of the 2006 mortgages in such securities found that 46% of them didn't meet the quality standards set up by the investment banks that packaged and sold the securities -- and even those unmet standards might not have been high enough.

The reason for these quality-control failures? The ratings agencies that were supposed to protect investors were competing to AAA-rate the securities, and the loan underwriters such as NovaStar Financial (NOVS) were paid on volume not loan quality. Unfortunately, the financial reform packages passed this year does not touch on this problem of misplaced incentives, so we could see a recurrence.

Wall Street firms that created these mortgage-backed securities hired Clayton Holdings to analyze whether they met the banks' underwriting standards. Clayton testified in front of the Financial Crisis Inquiry Commission (FCIC) which, somewhat surprisingly, is continuing its investigation despite the fact that financial reform legislation passed in July. His testimony was eye-opening for two reasons: It showed that the banks and ratings agencies knew the MBSs they were selling were full of bad loans, and that many big name Wall Street firms knew they were selling the financial equivalent of toxic waste.

Here are three of the firms that Clayton served:

• Citigroup (C): 29% of the Citigroup mortgages that Clayton sampled fell below underwriting standards but about 33% found their way into its MBSs;

• Goldman Sachs (GS): 19% of the Goldman mortgages that Clayton sampled fell below underwriting standards, but about 34% found their way into its MBSs. Meanwhile, Goldman was betting against mortgages for its own account and commented that it was not as bad as its peers; and

• Deutsche Bank (DB): 17% of Deutsche Banks loans "did not make the grade," according to The New York Times.

Clayton's information never made its way to MBS investors, nor did the ratings agencies who saw the data change their behavior. According to The New York Times, Clayton's then-president, D. Keith Johnson, told the FCIC, "If any one of them would have adopted it, they would have lost market share."

A Value Network Corrupted By Fees

It's easy to see why. As I wrote in August 2007 on BloggingStocks, DailyFinance's sister site, ratings agencies were competing for enormous fees from these Wall Street banks. Moody's (MCO) took in $3 billion to provide such structured finance ratings between 2002 through 2006, and the business accounted for 44% of its 2006 revenue -- up from 37% in 2002. But in order to win that business, the ratings agencies needed to put a AAA-rating on pools of mortgages that didn't deserve them. Ratings agencies were so compromised by that conflict of interest that 93% of the 2006 AAA ratings they issued on sub-prime MBS were later downgraded to junk.

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And the ratings agencies were a key part of a value network of firms, each of which had its hand out for fees -- except for the people who borrowed the money to buy their houses and the investors who bought the mortgage-backed securities. Those fee-getting participants included the mortgage originators such as NovaStar (which I suggested selling short at $106 in December 2006), the ratings agencies, the mortgage servicers, and the investment banks that underwrote and sold the securities.

But even the investors and some house buyers were tainted. Those subprime borrowers often went along with mortgage originators who suggested that they apply for no-documentation loans, then fill in their mortgage applications with exaggerated income -- the so-called liar loans that contributed to $100 billion in losses for the economy. And the institutional investors were hungry for a little extra yield and delegated their due diligence to ratings agencies.

As I wrote in an article for DailyFinance in July 2010, financial reform has not changed the mortgage-backed securities industry's flawed incentives or increased transparency in a way that would stop another MBS bubble from blowing up in the future. But that's probably irrelevant, because when it comes to financial crises, lightning never strikes twice in the same place.

Nevertheless, we can be sure that as long as the financial incentives remain intact for Wall Street to create and misrepresent investments to the unsuspecting and greedy buyers, we will see more financial bubbles ahead -- and those bubbles always, eventually, burst.