Thanks to the book and movie The Big Short, more people are familiar with why the economy collapsed in 2008. However, a lot of people still don’t understand the fundamental issue that caused the largest mortgage default in history – incentives. At a high level, the housing market collapsed because too many people took on too many mortgages that they couldn’t afford. If you dig deeper, you see that they took those mortgage because banks provided NINJA loans (No Income, No Job, No Asset). This allowed people to purchase multiple properties that they couldn’t afford with a 0% fixed interest rate that becomes variable after 3 years time. You can’t blame homeowners — after all, what would you do if the bank offered you large sums of money in exchange for a signature? The banks incentivized their employees to sell as many loans as possible, regardless of the quality of the applicant. Brokers were making money hand-over-fist selling multiple houses to people with no income. Herein lies the problem: why did they want to issue so many loans they knew would eventually go bust? Because they were able to group it together in a CDO (Collateralized Debt Obligation) and sell it to investors. That begs the question, why would any institutional investor purchase such an investment? Because they didn’t know.

The way a CDO, or any bond for that matter, gets rated is by a licensed rating company. There are currently six of them. The problem is that they’re all privately held companies. What happens if Moodys doesn’t rate your bond an A or higher? You go to S&P, and if they don’t you go to Morningstar, etc. This means that in order to earn business, you have inflated the rating of the bond. When investors are looking at what they believe to be a AAA bond, it might very well be a BB. Thus, they run a much higher risk of default for the return they are getting. 

When the government bailed out the banks in 2008 there were little repercussions on rating institutions. Sure, a few of them had to pay $500M+ in legal fees and fines, but they didn’t have to admit fault. Therefore, they received no further penalty or regulation. Now, the rise of CLO’s (Collateralized Loan Obligations) may create a similar result on the commercial side, as opposed to residential. If the economy were to bust, it would have a larger impact on financial conglomerates than it would middle-class homeowners. That being said, many would be out of work as the economy fell into turmoil. 

There’s only one way to stop this from happening. Rating agencies need to be either regulated more, or the government needs to provide at least partial oversight for credit ratings. There should be no incentive to provide a company with a better rating in order to earn their business. In an article from the WSJ, they quote the S&P as stating, “no rating business model is immune from potential conflicts of interest.” That is the truth, and we need to change the business model of these companies in order to avoid another collapse like that of the Great Recession.