Buffett's Take On The Credit Crisis

By Stephen D. Simpson, CFA | June 03, 2010 AAA

I think I have reached the point now where nothing tied to the housing bubble, the credit crisis and the recession surprise me anymore. The capper was the testimony of Berkshire Hathaway's (NYSE:BRK.A) CEO Warren Buffett in front of Congress on Wednesday.

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The Testimony
In his testimony, Buffett said that he did not believe that the CEOs of the credit ratings agencies deserve to be fired, and that the companies should not be criticized too harshly because they "made a mistake that virtually everybody in the country made."

Going a step further, he added that Moody's (NYSE:MCO) and McGraw-Hill's (NYSE:MHP) Standard & Poor's were "lulled into miscalculating the housing market by the narcotic of seemingly ever-increasing home prices." (For more insight, see Why Bad Bonds Get Good Ratings.)

Wow. Really?

The Rebuttal
With all due respect - and with full acknowledgment that Buffett is a billionaire many times over and I am not - that is bunk.

Here is how the ratings agencies worked, in a nutshell. Issuers like Wells Fargo (NYSE:WFC), Bank of America (NYSE:BAC) and Goldman Sachs (NYSE:GS) created various mortgage-backed securities, which were then assigned ratings by Moody's and Standard & Poor's in exchange for a fee. Making the potential for conflicts of interest even worse, these ratings agencies would often consult with the bonds' issuers about how to best structure them to achieve the desired rating (often "AAA", but not always).

That is a direct conflict of interest. After all, had the rating companies started downgrading already-issued bonds or applying harsher standards, there is the risk that their lucrative fee businesses would have dried up unless they all made the move together. What's more, investors have always found themselves stuck in regards to the ratings agencies - the savvier investors have always known that there were issues with the process, but Moody's, S&P and Fitch were pretty much the only game in town. (For more, see A Brief History Of Credit Rating Agencies.)

Not only do investors hate flying blind (bad info can be more reassuring than no info), but many hedge funds, pension funds and other asset managers have contracts with their investors that require them to incorporate these ratings into their allocation and buy/sell decisions. Consequently, I believe that the ratings agencies knew that they could be financially punished by the issuing companies and that there was little risk to their businesses from a mass boycott of investors.

I also happen to think that the notion that "nobody saw this coming" is patently false. Many investors, analysts and financial writers issued warnings as the housing bubble reached an unsustainable and dangerous level. While New York University business professor Nouriel Roubini and others may have been early on the call, they were right about the risks the economy was about to face, as well as on a lot of the salient details. The bottom line: there was an orgy of cheap debt leading to distortions in the housing market that would ultimately come crashing down. (For more, see The Fuel that Fed The Subprime Meltdown.)

After all, Moody's and S&P are supposed to be the experts; they are not supposed to be just like us as Buffett implies. They were certainly in a position to know that housing prices were at an absolute level that made little sense, and that the pace of growth was overheated for an economy the size and age of ours. On top of that, given that even regular folks joked about "liar loans" and flipping houses, it was entirely reasonable for the ratings agencies to sound the alarm that underwriting standards had fallen meaningfully. Last but not least, knowing exactly how the bonds were structured, who else was in a position to warn of the systemic risks once the first cracks started to appear? (For more, see Bond Rating Agencies: Can You Trust Them?)

The Bottom Line
I am sorry, Mr. Buffett, but I believe the ratings agencies are deserving of very harsh criticisms. I do not advocate a witch hunt, and I believe the congressional investigations have a sometimes-eerie resemblance to how France conducted show trials during the Revolution, but scorn and perhaps some regulatory oversight are not too much to ask.

Whether the CEOs of these companies should be fired is immaterial to me - that is a decision for the companies' boards to make. And hey, maybe you could argue that there is value in keeping around chagrined and chastened executives after all.

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