Fear and Greed Blog

Moody's recently published a report entitled Archaeology of the Crisis. I think it's definitely worth a read.

Given that Moody's is one of the agencies that many blame for, at least, part of the crisis, it is commendable that the report somewhat addresses the agencies' failures. Unfortunately, as is frequently the case, these failures are more obvious after the fact than they were prospectively.

Specifically highlighted is how loan originators, subprime loan borrowers, and market intermediaries were incentivized to provide limited information to other parties (including the rating agencies).

Also highlighted is the effect that differences in assumptions by market participants, particularly in relation to the definition of liquidity, had in the crisis. This disconnect was especially present in assumptions about how ratings do (or don't) reflect the market risk of a security (a "market-risk judgment") in addition to agencies' credit judgment (based on analyses of financial statements and the ability to pay).

The problem of how to consider the liquidity (defined, in this case, as a sufficient number of buyers and sellers), particularly over time, of securities (particularly unseasoned structured securities) is certainly significant.

The report also identifies the mark-to-market approach for valuation as one of the causes of the credit crisis. I have been concerned about the impact that financial reporting has been having on markets. It has been the financial equivalent of the "observer effect" where the measurement of the value of securities effects the value of those securities.

Accounting is supposed to provide information. It is designed to measure and report on asset values; not to impact those values.

The paper quotes from Raghuram G. Rajan's paper Has Financial Development Made the World Riskier and Claudio E. V. Borio's paper Change and constancy in the financial system: implications for financial distress and policy. Dr. Rajan is the Economic Counselor and Director of Research at the International Monetary Fund. Dr. Borio is the
Head of Research and Policy Analysis at the Bank for International
Settlements.

I recommend that readers peruse the Moody's report.