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  • Writer's pictureKirk Hartley

Bankers and Others Losing the Foreseeability Defense for the CDO Fiasco

Remember when Paul Krugman was exploding with outrage after Goldman’ Sach’s Mr. Blankfein testified to Congress that the financial meltdown was like a hurricane no one could foresee ? Remember the Epicurean Dealmaker’s admonition that the lack of foresight was self-induced?

Perhaps Mr. Blankfein drank his own Kool-Aid. But he was in fact dead wrong, according to this Jason Zweig article in the Wall Street Journal, which includes its own links to other materials. As the article describes, the CDO melt-down was foreseen in concept about seven decades ago by a University of Chicago economist named Melchior Palyi. (One can reasonably wonder if the "find" on Mr. Palyi’s work is related to litigation.) In a similar vein, the bloggers at The Conglomerate were last April writing about a 2002 University of Illinois law review as very prescient. That discussion is here.

Back to the merits. A fundamental problem according to Mr. Palyi? Lousy ratings of the safety of bonds. Key excerpts from the article are as follows:

Mr. Palyi, then teaching at the University of Chicago, was a vocal skeptic from the outset. Looking back into the 1920s, he found that investment-grade bonds went bust with alarming frequency, often in the same year they were rated. On average, he showed, a bank that followed the new rules would end up with a third of its bond portfolio going into default.

The record was so unreliable that it would be "still more responsible," Mr. Palyi growled, to "stop the publication of ratings altogether." He was especially troubled that the new banking rules switched the responsibility for credit safety from bankers—and even bank regulators—to ratings firms.

"From there," he warned, it "will have to be shifted again—to someone else," presumably taxpayers. Liquidity, Mr. Palyi argued, was being replaced by what he scornfully called "shiftability," a new kind of risk that could someday "be magnified into catastrophic dimensions."

In response to his criticism, government researchers studying how to apply bond ratings changed their method for calculating the performance of investment-grade bonds. By 1943 they had come up with an oddly contorted median that magically improved the track record of the ratings providers.

This switcheroo, recently documented for the first time by economists David Levy of George Mason University and Sandra Peart of the University of Richmond, legitimized the new regulatory model and flushed Mr. Palyi’s criticism down the memory-hole of history. Credit ratings, in the words of economist Lawrence White at New York University, acquired "the force of law."

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