Last December, Now On PBS  ran an intriging piece on the role the credit rating agencies played in the housing bubble. The industry has been attacked lately over the poor quality of its ratings of collateralized debt obligations (more on these later). The way forward is not clear.

In a forthcoming white paper, Matthew Richardson and Lawrence White argue that “…financial regulation may itself be the root cause of the problem since the basis of the NRSRO’s authority as the central source of information about the creditworthiness of bonds decreases competition and incentives to innovation.” An NRSRO is a “nationally recognized statistical rating organization.” The SEC (they will appear quite frequently in these blogs I suspect) designates which organizations can be NRSROs. The top three rating agencies are: Moody’s Investor Service, Standard & Poor’s and Fitch Ratings.

Richardson and White note in The Rating Agencies: Is Regulation the Answer? that “by creating a category…of rating agency that had to be headed, and then subsequently maintaining a barrier to entry into the category, the Securities and Exchange Commission (SEC) further enhanced the importance of the three major rating agencies.”

Banks are supposed to be adequately capitalized (well…who knew). One job of the regulators is to review these capital ratios. It has turned out that the Office of Thrift Supervision (a government regulator) allowed IndyMac Bank to back date capital infusions which enabled the bank to show itself in a better position than we now know it was.

Next up – a comment on the bond rating agencies.

Source: “Office let Indy Mac backdate capital,” Financial Times. www.ft.com

Always a favorite, the Economist has just issued its annual currency comparison.

There’s a section (382) in the Internal Revenue Code that limits the amount of loss a corporation can take when it acquires another corporation that has so many losses it can’t use them (net operating loss carryovers). The purpose of this section is to limit trafficking in what are called “loss corporations.” Last fall, the IRS issued Notice 2008-83 which states that banks will not be subject to the Section 382 loss limitation rules.

The purpose of the notice was to facilitate Wells Fargo’s acquisition of Wachovia. The Notice apparently allows Wells Fargo to apply the Wachovia losses to Wells Fargo’s prior year tax returns and claim refunds. Since California follows federal law, the state has already indicated that it will lose perhaps $2bn in tax revenues as a result of this notice.

Some commentators have suggested that the Treasury Department exceeded its authority by issuing the Notice, since the Treasury’s role is to administer tax law rather than change it. However, it has been pointed out that at the time Wachovia was about to tank (that’s a technical accounting term) it was holding billions of dollars in customers’ payroll funds. Had Wachovia failed, many people would have missed their payroll.

Source: “The IRS Bailout of the Bailout,” Thomas Wechter and Colleen Feeney Romero. “Notice 2008-83: The Ripples Keep Spreading,” George White. www.cpa2biz.com

In his book The Ascent of Money ( also a PBS show ), Niall Ferguson reports that mortgages used to be short term affairs, for perhaps three to five years. The principal on the loan was not paid until the end of the term as opposed to now where each payment you make is part interest and part principal. During the Great Depression, foreclosures spiked and the housing industry was devastated.

As part of the New Deal, the Home Owners’ Loan Corporation refinanced mortgages for periods up to fifteen years to keep people in their homes. Next, the Federal Housing Administration was created in 1934 to provide federally backed insurance for mortgage lenders. Four years later, the Federal National Mortgage Association (Fannie Mae) was formed to purchase and securitize mortgages in order to provide additional funds to lenders and home buyers.

Ferguson notes that “by radically increasing the opportunity for Americans to own their own homes, the Roosevelt administration pioneered the idea of a property-owning democracy. It proved to be the perfect antidote to the red revolution.” You’ll recall that it was the Bolshevik Revolution in 1917 that lead to the creation of the Soviet Union in 1922.

Thus, as Ferguson states, “from the 1930s onwards, then, the US government was effectively underwriting the mortgage market, encouraging lenders and borrowers to get together. That was what caused property ownership – and mortgage debt – to soar after the Second World War…”

The process of securitization basically works like this – a bank lends you money to buy your home. The bank then puts your loan, along with a lot of others, into a package which it sells to investors. This provides the bank with more money that it can lend out, starting the whole process all over again. The residential mortgage market is now approximately $10 trillion, half of which has been securitized.

In another of the same series of white papers previously mentioned (What to Do About the Government Sponsored Enterprises?) the authors note that “the structure of the GSEs leads to the classic moral hazard problem in which the lack of capital market discipline and cheap credit provides an incentive for excessive risk taking.”

Fannie Mae is one such government sponsored enterprise. The white paper authors argue that the current GSE model is flawed, because it introduces systemic risk into the system. The question that is raised (“what is the appropriate reform to be followed?”) is indeed a poser.

Any member of the American Institute of Certified Public Accountants who performs an audit must be peer reviewed. Cutting through the technical jargon, this means another CPA comes in and looks at your work product and passes judgement about whether you are doing your job properly.

Brokerage companies usually must be audited by firms that are registered under the Public Company Accounting Oversight Board (PCAOB) which was created under the Sarbanes-Oxley Act to help prevent fraud (how’s all that working out?). The SEC exempted companies like Madoff Securities from this audit requirement, which means that the firm auditing Bernie Madoff did not have to be registered with PCAOB or be peer reviewed. What we have here is a phenomenal failure of regulatory oversight.

Remember that Bernie Madoff was chairman of the NASDAQ Stock Market for a period of time.

Source: AICPA Issues Briefing