David P. Goldman, writing as Spengler in the Asia Times, diagnoses the heart of the Wall Street crisis, and lays out the solution to the rot in our financial markets. This is an important article to read and digest.

Goldman was himself an executive at Credit Suisse, and saw firsthand the generation of profit-making deals in the slicing, dicing, and resale of elements of risk associated with large bundles of individual home mortgages packaged as securities. In his customary clear-eyed, data-rich style, Goldman explains how it all works, and where it went wrong.

The ratings agencies - Moody's, Standard and Poor's, and Fitch - agreed that it was inconceivable that more than a third of a pool of subprime mortgages could default. If the banks got one group of investors to accept the first 35% of losses on the pool, the ratings agencies would label the rest of the pool default-proof, and give it a triple-A rating.　

The banks then went to the Federal Reserve and asked permission to increase leverage on what the ratings agencies called ultra-safe securities. Normally banks can hold about $12 of loans or securities for every $1 of their own money, but the Fed allowed them to own $70 of the phony subprime triple-A's for every $1 of shareholders' capital. Some of those bonds are now trading at 33 cents on the dollar.　

The ratings agencies, Fitch, Standard & Poor's, and Moody's, were enablers (my term, not his) of these packages of securities being accepted as financial instruments by the banks and other parties which bought and traded them. They have a conflict of interest: the issuer of a security pays the rating agency to give an opinion. The proliferation of mortgage debt-based securities was a bonanza for them.

For every Collateralized Debt Obligations, Moody's and Standard and Poor's received a fee in the low six figures, and these fees made up the bulk of their revenues. They acted as a adjunct to the investment banks' structuring teams, advising them on the best way to game their own models.　

In other words, the system of issuing securities is fundamentally flawed, with a conflict of interest built in. Goldman's solution is brilliant, adapted to the cyber era:

Make risk modeling a transparent business with universal access to data and models. The regulators should require large financial institutions to provide their internal data on defaults and delinquencies to the public.　

Many of the large banks have enormous amounts of data describing the characteristics of defaulting borrowers and the circumstances under which they defaulted. The Federal Reserve should collate this data into a single set, and make it available for download on its website.　

The large banks also should be required to publish their internal risk models. To require a private company to divulge proprietary information is a burden, but in light of the 2008 catastrophe, the public has a right to know how the banks are measuring their own risk.　

I believe he has nailed it. Attention: GOP field. Calling for transparency in the financial markets is a great strategy to counter the left's OWS propaganda and the Democrats' class warfare election strategy.

The ratings agencies were a product of 19th century technology. To examine financial data, one had to walk over to the company's offices and inspect hand-written ledgers and documents. In the internet age, they are no longer really needed. Disclosure is the way to restore confidence. It  is the elegant core reform that can cure the crisis of capitalism the left is so anxiouos to foment.

The practical problems lie in the transition period. If confidence in the ratings agencies evaporates, there are fears that financial markets will be seriously damaged.

See also: A Double-Dose of Spengler