Eric Falkenstein sums up 2008 through a ratings-agency lens:
I think 2008’s problem was mainly because after the rating agencies were exposed as making an error on their AAA and AA ratings, all investors viewed such securities skeptically. What was previously an asset class that did not require much thought, now need re-underwriting: evaluating the credit from the bottom up. This is very difficult, invariably there are many assumptions (especially for derivatives), and you find very quickly that there are lots of unknowns that are potentially dangerous. Usually, these assumptions are benign, but as the mortgage crisis proved, you can’t rest on ‘usually’.
I very much like the term "re-underwriting"; I think it’s a good way to think more generally about what happens after that other buzzword, deleveraging.
Re-underwriting doesn’t just happen among institutional investors with exposure to highly-rated structured products. It happens in banks, who are revisiting all of their loan portfolios, deciding who will get their loans rolled over and who won’t. It happens in the mortgage market, of course, every time a homeowner tries to take advantage of lower mortgage rates by refinancing. And more conceptually, it happens whenever any investor, even an individual with just a few thousand dollars in an index fund, stops to really wonder, for the first time, exactly why he’s taking these risks with his money, and whether the potential upside compensates for the potential downside.
And there’s certainly lots of re-underwriting going on in the world of hedge-fund investors, as Falkenstein says:
Anyone doing due diligence needs to do the simple things, like seeing if a ‘conversion strike strategy’ is remotely plausible in generating promised returns.
It’s actually harder than that, because re-underwriting conversion strike strategies is not simple but rather impossible for 99% of the people invested in hedge funds. So those people need to re-underwrite not tractable conversion strike strategies, but rather something much vaguer: the trustworthiness of their investment advisors. And how does one even begin underwriting the trustworthiness of an institution like Fairfield Greenwich?
A well-functioning capitalist system is based on high degrees of trust. Eventually, inevitably, that trust is going to be gamed and taken advantage of. And then you get a crash, which ends in a mire of mistrust and recrimination. How to get out of that mire is the problem facing us all today.