Kass: Four to Blame for the Subprime Mess

Many of these mono-line subprime lenders grew from nothing to originating billions of dollars of mortgage loans almost overnight. Their rush to lend and helter skelter growth relied on the candor of the mortgagees and not on common sense, prudent lending or reasonable underwriting standards.

The growth in subprime-only originators was irrational, but the industry will now be rationalized and the marginal lenders will go bankrupt. And, in the fullness of time, the more diversified lenders will benefit from their demise.

Culprit #3: Wall Street was no smarter than a seventh grader.

The role of the brokerage community in the packaging, warehousing and trading of mortgage securities is immense, with about a 60% share of the mortgage financing market. After tax shelter abuses in the early 1980s, junk(y) bonds in the late 1980s, overpriced technology stocks and ludicrous IPOs and disingenuous research reports in the late 1990s, one would think that Wall Street had learned its lesson.

It has not.

Defending the indefensible -- despite the "policing" of the SEC and Gov. Spitzer's initiatives -- remains Wall Street's credo. Time and time again, the major brokerage firms exist for the purpose of selling product (stocks and bonds), not for providing objective research or for the commitment to client's profitability. The higher a market surges, the easier it is for Wall Street to peddle, and package, junk.

The magnitude of the potential gains are always too attractive and tempting particularly as product demand swells into another cycle excess, as it did in subprime. Astonishingly, even the obligatory emergency conference calls intended to persuade investors that all is well were superficial and failed to disclose the inherent conflicts that each and every multiline brokerage has.

The major brokerages will be litigated against -- again. They will pay large fines but will proceed in business until the next bubble -- which they will also capitalize on.

Culprit #4: The rating agencies were no smarter than an eighth grader.

The little-known secret in the subprime market is that the principal ratings agencies have been lax in their downgrades of subprime paper and securitizations. This should not be considered a surprise, because like their Wall Street brethren, they prosper from the rising tide of credit issuances. In doing so, like a teacher who has turned his back on a boisterous and disobedient class, those recalcitrant agencies -- Moody's, Fitch and S&P -- have ignored the erosion in credit quality and abetted the rush and market share taking of subprime lending.

According to Jim Grant's Interest Rate Observer, downgrades at Moody's were even with upgrades in 2005. In 2006, downgrades/upgrades rose slightly to 1.19 to 1; this compares to the historical downgrade/upgrade ratio of 2.5 to 1. Importantly, until downgrades are issued by the agencies, investors routinely carry their investments at cost, or par -- downgrades force investments to mark to market ... and sell.

The rating agencies will likely go unscathed because they always do.

Programming note: I discussed the "four culprits" and my broader view of the subprime debacle on Aaron Task's Real Story podcast last night.