The movie "The Big Short" provides a lesson on why the Great Recession happened

I picked up on this as well in the movie. Robert Shiller actually goes into this in his Yale classes you can listen to on YouTube. He basically said the original Mr. Moody is spinning in his grave at the prospect of accepting money from the people they are rating.

To me, it seems like a opportunity wasted. If Moody's or the SP had started rating these as they actually were, it would have put the other out of business once everything hit the fan. If what the agencies are selling is trust and objectivity, the one who actually was able to objectively rate those products could have put the other out of business. It was a chance for one or the other to put a stake in the ground and say, "look at which one of us is objective".

Michael Lewis and Adam McKay are each very good at describing or illustrating the feel of the banking environment at that time and how crazy it was, but neither seem to have a good understanding of what caused the crisis.

The credit rating agencies were one failed link in a chain of many, but they were not the primary force driving the imbalances. The federal government was subsidizing banks to hold lots of mortgage derivatives products in various ways. One of these was by giving regulatory preference to a few rated agencies, which in turn had incentives to give high ratings.

However, the main problem was not (as The Big Short seems to suggest) that toxic assets got misrated because credit rating agencies and big banks were stupid. Rather, the main problem was that the federal government basically was the market, and anybody who didn't jump aboard the gravy train got left in the dust. In many cases, the supposedly junk CDOs and MBS that nobody wanted to buy actually ended up paying out okay. It wasn't that the AAA ratings for certain tranches of MBS were necessarily wrong. In some cases they were wrong, but in other cases the toxicity of the mortgage derivatives were exaggerated and the AAA ratings worked out okay.

The key problem was that the assets got caught in a situation where they could not be properly valued, and there was no transparency about what they represented, and nobody wanted to buy them or mark them down for fear of being punished by the market. How did they get this way? Because they were put together so quickly and haphazardly in order to jump aboard the government subsidies bandwagon.

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It's the most obvious conflict of interest in the financial world and nothing has been done to change that.

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Having worked on CCAR at one of the big banks, I can assure you that Dodd-Frank did change the situation very much. If you look at the NRSROs, you will see that there were 10 (now 9) rather than the Big 3. Some, such as Egan-Jones, have different business model to try to eliminate the conflict of interest you mentioned.

Dodd-Frank did much more than reform NRSRO regulation though--it also implemented tons of risk model stress testing requirements for the big banks to apply every year to all their asset portfolios. So in terms of holding enough regulatory capital to withstand "severely adverse" macroeconomic or other scenarios, the banks must now do very comprehensive work on showing how all their derivatives portfolios will behave under severely stressed conditions. The sometimes use vendor models for this (such as Moody's Analytics), but even for vendor models they are required to do layers upon layers of documentation, stress testing, validation, and internal auditing, to ensure that they have a conservative appraisal of worst-case scenarios.

I generally like Jeb Bush, but he gave a terrible argument against Dodd-Frank last November that was totally wrong: LINK.

We definitely don't need to raise capital requirements for the big banks. There are valid criticisms I would make about Dodd-Frank in that it (1) creates mountains of mountains of useless and unnecessary paperwork, and (2) effectively turns banks into public utilities, and this does tend to concentrate risks somewhat by erecting huge barriers to competition. However, the problem regarding banks' over-reliance on the NRSROs is no longer a real problem in my opinion.

The problem that remains with us is the problem of the federal government continuing to provide subsidies in all kinds of different ways, with long-term consequences that are difficult to predict.

Yes, but the rating itself is no longer as important as it used to be.

The CDOs and such multiplied the effect of what could've been a more "traditional" economic downturn

Here is a good article by WSJ about the film LINK

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And what kind of stress tests do pension funds, bond mutual funds and ETF's perform on the bonds they buy?

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The most rigorous CCAR stress testing requirements apply to banks with over $50 billion in assets, but other Dodd-Frank Act stress testing (DFAST) applies to financial institutions having between $10-50 billion. The NCUA has recently required DFAST stress testing for even credit unions: LINK.

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Don't those funds continue to rely upon the rating agencies who continue to operate with a major conflict of interest?

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Yes, and you're correct in pointing out that the residual risk from this business model is still there, but (A) I don't see a silver bullet fix to this problem, and as I posted earlier, (B) the risk has been mitigated to a significant extent in multiple ways. A NRSRO cannot get away with ratings that do not take stress testing into account, because all the banks who use their ratings will need to do some of that same work independently.

There is still the problem of smaller financial institutions and retail investors further down the chain over-relying on sloppy credit work, as you mentioned, but I imagine that most of what the little guys buy is also held by a lot of larger players with assets over $10 billion who do stress testing. Plus, there are other NRSROs out there offering fee-based services to subscribers without the conflict of interest that S&P retains, so the smaller investors are free to subscribe to those if they want.

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Are the large banks required to perform the stress tests on their trading book or just on their hold-to-maturity portfolio?

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Yes. Generally the former will be called "market risk models" (lots of daily VaR calculations with shock scenarios applied) and the latter will be called "credit risk models" (lots of panel regressions and rating transition matrices, with details about how those ratings might migrate under stressed economic scenarios).

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The credit rating agencies were one failed link in a chain of many, but they were not the primary force driving the imbalances.

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I would agree with this. I would go further that the only institution I would have bailed out would have been AIG. And I'm not even sure about this. I don't have time to get into a lot of why I believe this, but AIG was a failure to properly regulate what should have been properly reserved for as an insurance product, rather than a financial product. That's really, really an oversimplification, and in practice it wouldn't matter where the regulations for properly reserving what amounted to loan default insurance would have come from.

Anyway, to place this all on credit rating agencies is not accurate in my opinion, and there is Congressional testimony that supports my opinion.

One on of the business channel the guys that shorted swaps said investment banks and banks were well aware that their packaged loans were garbage.

We cannot absolve the banks on this completely, nor is this all at the feet of the federal government.

Going forward from this, the healthiest thing would have been to let several banks and other financial institutions go broke, withstand the depression, and let the market place replace the institutions that went broke through their own malfeasance.

But that's not what most agree with. We instead went a Keynesian direction, and many deluded themselves that this was a fiscally conservative approach.

There is some really, really good reading on this subject, and I would think still a lot of video footage of the Congressional hearings available on CSPAN that would add some facts to a blanket statement that only one or two particular parts of the financial system caused this. Which a simple Google search proves to be inaccurate.

Someone down voting me away who is basing their entire understanding on a movie, has likely never read anything further on the subject, nor watched one Congressional hearing.

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It's just a NC credit union.

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C'mon, Doc, this isn't your first rodeo. You know Moody's is selling its 'stress test' model to as many institutions as they can.

They aren't going to develop an elaborate stress test model that gets the Fed's Good Housekeeping Seal of Approval for just one credit union in North Carolina. Their sales brochure ( LINK) says their model is applicable for "regulatory scenarios for more than 50 countries."

Moody’s Analytics Stress Testing Suite

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Moody’s Analytics Stress Testing Suite enables institutions to more easily implement and execute collaborative, auditable, repeatable, and transparent stress testing programs. It integrates Moody’s Analytics credit loss data, economic scenario generation, advisory services, loss estimation, pre-provision net revenue (PPNR) modeling, and regulatory reporting capabilities with your stress testing program. This flexible, modular, open-architecture solution integrates with existing systems, as well as other Moody’s Analytics solutions.

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Good movie but I liked the book a lot better.

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Book was good although not necessarily accurate in some aspects. Thought the movie was meh and probably due to how it was made to make the subject matter more appealing to a broader audience, wife gave up after 20 minutes.