Earlier this month, Erik Gordon, an American finance professor, posed a pointed question relating to Fool’s Gold, my book about the 2008 financial crisis: should we now feel some déjà vu? Not because of what is happening with tech stocks nor with Wall Street demands for deregulation. Rather, the issue (once again) is credit ratings.
Before the 2008 crisis, there was a proliferation of financial products that could be used for regulatory arbitrage, playing with the Basel rules to enable banks to reduce the capital reserves they held against defaults. Credit ratings were crucial to this.
To invoke a Fool’s Gold analogy, this game of regulatory arbitrage turned bankers into financial chefs: they sliced up risky loans (like meat scraps), remixed them into new products (like fancy sausages), which got seals of approval from rating agencies (like food critics). And it worked well until rotten meat entered the sausage mix and investors panicked in a financial food poisoning scare.