I’m not an economist. I think it’s important I begin this post by saying that. In fact, I’m an IT Tech who happens to be interested in the way too many other things, like the economy. What can I say, I like having a job so it’s important to me that the economy is healthy. It’s important to you too. What I’m about to attempt to do is explain what I understand about the current lending crisis that is about to severely impact our countries economic health.

There’s a lot of talk about a crisis in subprime lending. These are loans given to people with less than perfect credit. The reality is that there are systematic reasons why banks chose to invest so heavily in loans that seem unwise on their face.

We’ve seen the effects an economic downturn can have on the nation at large. In early 2001 President Bush began an endless repetition of the mantra that Clinton had ruined our economy. He said it ever so nicely, for instance in March 2001, “You see, it’s the President’s job to look for warnings of economic trouble ahead, and to heed them, and to act.” With economics, perception often becomes reality and that constant negative drumbeat along with the end of an economic boom based around new dot com businesses led to a several year recession which cost the country about 2 million jobs.

That was small beans.

The current lending crisis could easily lead to a complete halt in growth in the US economy. Estimates I’ve read point to the potential for a halt in economic growth to drive unemployment from 4.7% of the population to 6.4%. This would be a loss of 3,000,000 jobs. Those are 3 million families who suddenly will find their lives exponentially more difficult.

Right now the bulk of the economic crisis that is discussed in the media is related to predatory mortgages that were given out to poor families regardless of their ability to repay. This is really the tip of the iceberg though. For a more complete picture of what is happening in the lending market, I’m going to attempt to summarize a talk given recently by David Einhorn which I will quote from liberally.

In short, he argues that we have learned nothing from the recent mortgage meltdown. We’ve decided that what happened was purely that a lot of bad people took advantage of a lot of people who didn’t fully understand the terms they were accepting for their mortgages. We talk about it purely as a crisis related to subprime mortgages when really it is a lending market crisis caused by major flaws in our securities evaluation systems.

This crisis came for exactly the right reason. There is a big flaw in the structure of our credit markets. The bad structure induced lenders to take imprudent risks and make imprudent loans, which, of course led to losses. What is unique about this crisis compared to others is that the losses are in illiquid, opaque structures scattered around the world.

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In my view, the credit issues aren’t just about subprime. Subprime is what the media says. Subprime is what parts of our financial establishment says. Subprime is about them – those people and the people who made foolish loans to them. The word “Subprime” is pejorative. Subprime is not about us, for we are not subprime. How convenient to be able to pass the blame.

There has been much talk from politicians and pundits about predatory lending – that is making loans at high rates to people who couldn’t reasonably be expected to pay them back. They are right, that is a bad practice, but that is not what’s shaking the markets. At issue today is that lenders of all sorts have lent too much money and did not demand enough interest to compensate them for the risks they took. There has been a colossal undercharging for credit across the board.

The core of the flaw is that securities are evaluated by several private bodies, the major ones being Stanard & Poor’s, Moody’s and Fitch Ratings. These companies issue ratings for each security that express the level of risk involved in purchasing the security. These ratings heavily influence which securities financial firms invest in and have a direct effect on the interest rates charged for similar loans. There is nothing wrong with a private body performing this task, but there is a serious problem in how they make their profit.

Have the rating agencies developed an expertise in analyzing these structures? Perhaps, but more pertinent, they are the only ones who can evaluate them, because they are the only ones with the detailed information about the structures. The underwriters give the rating agencies much more information than is contained in the prospectus. In their evaluation of corporate credits, rating agencies are exempt from regulation FD. This means that they can receive confidential information not available to other market participants. This is kind of like a confessional where the priest delivers a public opinion on the extent of your virtues and sins – and your spouse has to guess what a AAA or BBB means about your fidelity.

In other words, these ratings agencies know things every other investor never gets to find out. You know if you’re buying or selling junk bonds or pushing a strong investment because they told you so. Their job is to use the inside information they have to good advice to investors so they can properly understand the risk they are taking on.

Now if you were looking for inside information, let’s say on a boxing match you wanted to bet on, who would you want to get that inside information from? Would you rather get that information from a person who you paid, or would you rather listen to the guy your bookie has paid? The guy you paid has a financial incentive to give you the information that will help you win the bet. The guy who your bookie paid has a financial incentive to give you the information that will help your bookie win the bet. I’d listen to the guy who has my interests in mind.

Unfortunately, Moody’s, Stanard & Poor’s and Fitch all are paid by those looking to have their securities evaluated. Therefore, the three major firms are competing to be the best at attracting customers and getting those customers money. In this case that’s the sellers of securities. In effect, there is a financial incentive to give the highest ratings in as many cases as possible as that will make your firm more money.

There is also extra pressure to not always tell the whole truth about the health of an investment. Just as Presidents can affect the economy by exuding confidence or forecasting doom, by letting the cat out of the bag on all the pending trouble the ratings agencies run the risk of causing a panic in the market. This would further erode the financial health of those paying the bills. By telling the whole truth about the current crisis many banks would be forced to disclose the full extent of the hit they’ve taken at once.

When ratings agencies are more concerned about the effects of the rating actions than on the accuracy of the ratings, they become part of the Wall Stree “confidence” machine and surrender their ability to fulfill their statutory role in objectively analyzing credit.

To make things more complicated, rather than just evaluating all securities on one scale, they have decided to evaluate different securities on different scales. Therefore, a bond issued by a city or town, despite the fact that it is highly unlikely to be defaulted upon, may be issued a far lower rating than a corporate bond with a far higher likelihood of going bust. What’s worse, when securities are cleverly packaged, they can achieve a higher rating than any of them would individually, not because they are a better investment as a package, but because packaging them changes the ratings system that applies to them.

The result is that municipalities are charged higher interest rates on their bonds than corporate lenders, not because they represent a greater risk but rather because they’re in a different ratings scale. On this scale a municipal bond rated just above a junk bond is half as likely to go bust in 10 years as a corporate bond with the highest rating. This has led, according to Einhorn, to taxpayers paying $5 billion a year in interest they shouldn’t need to pay.

Is it proper to have the same ratings mean different things in different classes? Probably not. For many bond buyers the statutory requirements are determined by the credit rating. If the bond is rated investment grade, then it is eligible for purchase. No distinction is made for buying the “good” A rated bonds versus the “bad” ones. The bad A rated bonds don’t come with special warning labels. They tend to find themselves in the portfolios of the least sophisticated ratings-driven portfolios like pension funds.

This is simply because investors aren’t given the proper information to understand the risks they are taking on. Were the system designed to rate all investments on a single scale it would be obvious what the wise investment is. The cost of financing public projects would go down as the bonds that pay for them cheapen. Investors also would be able to avoid dangerous subprime investments.

When securities comprised of bundles of questionable investments can be assured an inflated rating, it makes it more financially viable to make the initial bad loan. Despite the fact that lenders know the loan is likely to go bust, they are sure they can sell the risk before it’s too late as a wise investment. We need to eliminate the short term financial incentive to make an economically disastrous decision.

Einhorn suggests that we change to a model where all the information that Stanard & Poor’s, Moody’s and Fitch get also goes to the public at large. Those firms would instead have to go into the somewhat less lucrative business of competing to sell their services instead to the investors who will be purchasing the securities they are rating. In this case they will have the investors’ best interests in mind. If that leads to fewer people preying on poor Ms. Dailey, I’m all for it.