The Role of Ratings in the Subprime Mortgage Crisis
Excerpted Introduction (via Akos Rona-Tas @ Ualberta)
The subprime mortgage crisis developed in the U.S. and became a full-blown disaster in 2007. Its effects have been rippling through the entire world economy ever since. The crisis in the U.S. mortgage market was, first and foremost a colossal failure of credit rating agencies whose job was to evaluate individual borrowers and the financial products created from individual loans through the securitization process.
Consumer and corporate rating agencies have followed different philosophies in their evaluation process. Consumers have been evaluated in highly formalized, automated fashion while the financial products created from the aggregation of individual mortgages were subject to a process that while made ample use of formal analytic techniques, emphasized the indispensability of human judgment.
Both economic theory (Debreu 1959, Arrow 1951/1968, for a review see Yonay 1998, Weintraub 2002) and cognitive psychology (Dawes 1979, Dawes et al. 1989, Grove and Meehl 1996, Gove et al. 2000), suggest that rational formalization of decision involving careful, objective quantification and calculation, improves the quality of choices and both economic theory and common sense suggest that the higher the stakes, the less actors will put up with inferior methods of decision making. Therefore, one would expect that the incentive to formalize decision making should be much greater in corporate than in consumer lending. It is, therefore, somewhat unexpected, that corporate lenders tend to rely more on the art of subjective, if informed, judgment from credit rating agencies while consumer lenders assess their loan applicants with the benefit of the highly formalized evaluation provided by consumer rating agencies. In this paper, we ask the following questions: What can we learn about the limits of formalization in consumer credit scoring and expert judgment in company credit rating? What was the role of formalization in the subprime meltdown?
Most interesting sentence:
“A key factor responsible for the subprime debacle of the rating agencies is their over-reliance on formalization.”