The Fed, Treasury and the Senate Budget Committee appear to have a favorite private sector economist, one who has managed to become a favorite even though he works for a unit of the same rating agency whose analysis is intrinsically tied to both the market, banking and housing crisis.

Mark Zandi of Moody’s Economy.com is routinely trotted out as an independent expert. He was the sole economist at the August 17 Treasury Conference on the Future of Housing Finance, the Fed’s REO and Vacant Properties conference and has now testified at the September 22^nd Senate Budget Committee hearing on “Assessing the Federal Policy Response to the Economic Crisis.”

Never mind that, based on Zandi’s record, either his analysis is just wrong or his independence is compromised. Everyone seems to like to hear the guy who is saying what people want to hear, even the press appears to prefer “feel good” analysis to considering the accuracy of his record.

I like Mark Zandi quite a bit. He is collegial, considerate, considered and smart. But his optimism is helping Washington avoid addressing the reality of our economic problems and the structural issues that must be addressed before our economy can sustain renewed growth.

So why is Zandi the Beltway’s Mr. Congeniality? That question is easy to answer, I think.

Zandi advised Sen. John McCain (R-Ariz.) in his presidential run and is widely respected in the business community. He isn’t seen as a liberal, or a partisan. But, for months now, he has argued for more stimulus, hailed TARP and generally sided with Democrats on major economic questions. Ergo, Democrats get to cite a Republican when arguing for their policies, knowing said Republican adviser will publicly back them up. If Doug Holtz-Eakin did, Democrats would happily cite him too.

None of this is to question Zandi’s work or to say anything about his politics, of course. It is just to note he is so frequently cited because it is so uniquely expedient for Democrats to cite him.

Without those extraordinary measures, they say, the United States’ GDP would be 6.5 percent lower, the unemployment rate would be 3 percentage points higher, there would be 8.5 million fewer jobs and the economy would be experiencing deflation. Blinder is a professor at Princeton and a former Fed official. Zandi is the chief economist at Moody’s Analytics and a former adviser to Sen. John McCain’s (R-Ariz.) presidential campaign.

The economists also note that the stimulus — the $787 billion American Reinvestment and Recovery Act — had less impact and proved less important than the government’s monetary policy and financial-market stabilization measures, like the Fed buy-up of mortgage-backed securities.

Zandi and Blinder write:

It is understandable that the still-fragile economy and the massive budget deficits have fueled criticism of the government’s response. No one can know for sure what the world would look like today if policymakers had not acted as they did — our estimates are just that, estimates. It is also not difficult to find fault with isolated aspects of the policy response. [...]

While all of these questions deserve careful consideration, it is clear that laissez faire was not an option; policymakers had to act. Not responding would have left both the economy and the government’s fiscal situation in far graver condition. We conclude that [Federal Reserve Chairman] Ben Bernanke was probably right when he said that “We came very close in October [2008] to Depression 2.0.”

“I hope that we can get this done — we only missed it by one vote yesterday. I hope we can pass it tonight before we go home for the 4th of July,” Harkin said this morning during a conference call with reporters.

“Moody’s Analytics says that the biggest bang for the buck we can get for government spending during a recession is food stamps because people spend that money right away. Second only to that are unemployment insurance benefits,” Harkin said.

The Moodys.com study he’s referring to from earlier this year found that extending unemployment benefits generates $1.63 in economic activity for every $1 spent by the government.

“Quite frankly, the worst thing I think we can do in the recession that we are in right now is to not extend unemployment insurance benefits,” he said. “That will drag the economy down every further.”

Today, June 15

• Merging the Office of Thrift Supervision and the Office of the Comptroller of the Currency
• Provisions relating to insurance and private funds
• Reforming the credit rating agencies

Wednesday, June 16

• Investor protections and regulatory improvements
• Executive compensation and corporate governance
• An audit of the Federal Reserve, Fed governance and emergency liquidity provisions

Thursday, June 17

• Systemic risk regulation and resolution authority, including payments, clearing and settlement for counterparties of shuttered banks

Next week 

• The structure of the Consumer Financial Protection Agency
• Predatory lending
• Credit and debit card interchange fees
• Remittances
• Access issues
• Prudential regulation
• Derivatives

In my mind, the story here is less that Goldman, the world’s most profitable bank, failed to comply. The story is that this is the third instance of a company or individual neglecting to provide or keeping information from the panel — and, in the minds of journalists, three makes a trend. Notably, a subpoena comes after the FCIC has made repeated requests for information. First comes a nice letter. Then comes a nastier letter. Sometimes, after that, a phone call or another document. The subpoena comes only when it is clear the company or individual is being recalcitrant.

Perhaps Moody’s, Berkshire Hathaway’s Warren Buffett, and Goldman Sachs — the three the FCIC has subpoenaed thus far — believe that by refusing to comply they are telegraphing their independent, anti-regulatory stance, or belief that the FCIC is too accusatory or not important enough. Perhaps they are just slow to respond. But perhaps they should consider that Congress created the FCIC for the good of the American citizens who lost trillions in the financial crisis and recession and were forced to bail out the financial sector.

Warren Buffett (Xinhua/ZUMA Press)

Testifying before the Financial Crisis Inquiry Commission this afternoon, Warren Buffett — the legendary value investor who heads Omaha-based investment giant Berkshire Hathaway — defended the behavior of the country’s credit ratings agencies and his own role in them, while acknowledging that the model under which they operate creates a flawed system of incentives.

[Economy1] The FCIC, now notorious for its grilling of Wall Street executives, mortgage originators, government regulators and others complicit in the boom and bust, summoned Buffett to discuss the ratings agencies, which assess the chance that a financial product will default and assign it a grade that determines its price and risk. Berkshire Hathaway is a major stakeholder in Moody’s, one of the country’s two main ratings agencies — a lucrative duopoly that gave wildly inaccurate assessments of mortgage-backed securities before the crash.

As a stakeholder, one might have expected Buffett to defend the industry. And he did to a certain extent, arguing that Moody’s executives were not negligent and do not deserve to be fired, for instance. But he also undercut his own defense, noting that he “hates” the ratings agency business model and seemingly admitting that he invested in Moody’s for its profitability rather than its soundness. It made for an anemic stand for a business on the verge of major regulatory changes.

The so-called “Oracle of Omaha” largely shifted the blame from himself and Moody’s, arguing that systemically important financial firms that require government life support should have their shareholders wiped out and managers fired — but not Moody’s. And he did not acknowledge the ratings agencies’ unique role in precipitating the financial crisis, instead saying that Moody’s main mistake was to miss the trillion-dollar housing bubble along with “the rest of America.”

He actually had to be compelled to testify before the commission, declining two invitations before the FCIC subpoenaed him, saying, “YOU ARE HEREBY COMMANDED to appear and give testimony.” Still, the 79-year-old appeared unruffled and energetic, dressed in a dark suit and a red tie, seated alongside the chief executive officer of Moody’s, Raymond McDaniel.

Bill Thomas, the vice chairman of the FCIC, broke the tension in the room as he opened his questioning. “Notwithstanding the subpoena, I want to thank you for coming,” he began.

Buffett quipped back, “I want to thank you for the supboena!”

But the exchange soon became heated, with Buffett providing defensive and gruff answers to questions. Phil Angelides, the head of the FCIC, said that he had found “a lot of fingers pointing away” and “very little self-examination” at the credit ratings agencies. There were “significant failures in the product your company offered,” he said, and ratings “proved to be highly defective, not just by a small measure, but by a large amount.”

Angelides added, “If we flipped a coin, it would have been five times more accurate” than Moody’s ratings of structured products — 90 percent of which needed to be downgraded.

But Buffett said that Moody’s just made the same “mistake that 300 million Americans made” and that he did not believe its business model should change or its management should be fired. “Rising prices are a narcotic,” he said, a narcotic that intoxicated investors including himself.

Angelides pressed him on whether he should have seen the housing bubble, given that government regulators and market participants started sounding the alarm in 2004. “The Cassandras were there,” Buffett conceded. “But who was going to listen to [hedge fund investors] John Paulson in 2005 or 2006 or Michael Burry?” (Both Paulson and Burry called the bubble early and shorted the housing market, making billions as the economy collapsed.) Buffett said, “I recognized something pretty dramatic going on,” but he thought it was a “bubblette” rather than a “four star” bubble.

He also said that while he recognized real faults in the credit ratings business, he did not think that changing the model was necessary. “I hate issuer pay,” he said, describing the system by which the companies that produce financial products pay agencies like Moody’s to rate them — a conflict of interest at the heart of the business, as financial firms pressure agencies to give them better ratings and shop around for triple-A marks.

But Buffett said that he did not think anything else would work better. When asked whether the United States should adopt Sen. Al Franken’s (D-Minn.) proposal to have the government assign a rater to a financial product, he demurred. “I suppose it could happen,” Buffett said. “I’m not arguing this is the perfect model. I’m just saying it’s hard to change.

“The wisdom of somebody picking out raters — is that going to be perfect? I don’t know,” he continued, noting that the Nebraska insurance authorities tell him which ratings agencies he needs to hire to rate his products.

At another point, Angelides criticized the “very structure of credit rating agencies,” saying, “It does seem in the end, there’s lots of upside but very little downside” if Moody’s and Standard and Poor’s misrate financial products. “I think much of corporate America is tilted that way,” Buffett said, before wanly arguing, “We’ve seen significant downside” due to hits to Moody’s stock price.

Buffett also acknowledged that he personally has little investment in accurate ratings. “We hope for misrated securities, because it gives us a chance to earn a profit,” Buffett said. “I think they misrate us! [Moody's] have us a notch below Standard & Poor’s.”

Douglas Holtz-Eakin, the Republican former director of the Congressional Budget Office, repeatedly noted that Buffett’s testimony showed that ratings agencies were profitable due to their duopoly, rather than the usefulness of their ratings. Buffett did not disagree, instead noting that Moody’s and Standard and Poor’s ability to “set prices” — to somewhat arbitrarily name the fee for a rating, due to a lack of competition — made it an attractive business.

Buffett conceded that as an investor, he considered the duopoly “a wonderful economic model for the business.” And he added that Berkshire Hathaway does not rely on credit ratings agencies to analyze financial products, instead doing its own due diligence in-house.

He later said that ratings agencies might function best as a monopoly. “If there were 10 ratings agencies, all equally well-regarded [and] all acceptable to the market, they would compete on price, laxity or both,” he said. “If there were just one ratings agency, they would have no reason to compete.” He also noted that Berkshire Hathaway is reducing its stake in the company.

In practice, “[the] agencies allowed Wall Street to impact their analysis, their independence and their reputation for reliability,” Levin said this morning. “They did it for the money.” In short: The banks gamed the ratings agencies, and did it well. Here’s from the summary of the Levin report:

“Investors trusted credit rating agencies to issue accurate and impartial credit ratings, but that trust was broken in the recent financial crisis,” said Levin. “A conveyor belt of high risk securities, backed by toxic mortgages, got AAA ratings that turned out not to be worth the paper they were printed on.  The agencies issued those AAA ratings using inadequate data and outmoded models.  When they finally fixed their models, they failed for a year — while delinquencies were climbing — to re-evaluate the existing securities.  Then, in July 2007, the credit rating agencies instituted a mass downgrade of hundreds of mortgage backed securities, sent shockwaves through the economy, and the financial crisis was on.  By first instilling unwarranted confidence in high risk securities and then failing to downgrade them in a responsible manner, the credit rating agencies share blame for the massive economic damage that followed.”

From 2002 to 2007, the credit rating agencies earned record profits, reporting $6 billion in gross revenues in 2007.  They also allowed the drive for profits and market share to affect ratings.  Knowing that Wall Street firms might take their business elsewhere if they didn’t get investment-grade ratings for their products, the agencies were vulnerable to pressure from issuers and investment bankers.  As one Moody’s executive wrote in October 2007: “It turns out that ratings quality has surprisingly few friends: issuers want high ratings; investors don’t want rating downgrades; short-sighted bankers labor … to game the rating agencies.”

The credit rating agencies still, three years into the crisis, have a conflict of interest at the heart of their business. The financial firms that produce the financial products, not the financial firms that buy them, pay for the supposedly independent ratings. In a released email, one S&P employee describes colleagues in the company’s mortgage unit: “They’ve become so beholden to their top issuers for revenue they have all developed a kind of Stockholm syndrome which they mistakenly tag as Customer Value creation.” The Dodd bill creates an office of credit ratings within the Security and Exchange Commission, and increases oversight. But it does little to change the underlying problem.

Rep. Lloyd Doggett (D-Texas)

Last week, as House Democrats took to the floor with near-unanimous praise for legislation to help the unemployed and stimulate the fragile economy, Rep. Lloyd Doggett (D-Texas) offered a wildly different assessment.

“This bill,” he said, “represents a textbook example of how not to deal with the economic challenges that our country faces.”

[Economy1]The Texas Democrat wasn’t talking about the extension of unemployment benefits at the heart of the bill, but an amendment providing the nation’s businesses — even the largest corporations — with tens-of-billions of dollars in tax rebates to stem recent losses. That provision, Doggett claimed, is less an economic stimulant than it is “a corporate giveaway” at the expense of taxpayers. It didn’t help the congressman’s mood that the Democrats’ bill allocates more than four times the funding to the business tax than it does to extending unemployment insurance.

“Today’s bill allocates $2 billion to the winner and $10 billion to the loser,” he said.

Indeed, although the jobless benefits are the centerpiece of the Democrats’ bill, they represent a mere $2.4 billion of the spending, according to the Congressional Budget Office — or just 10 percent of the $24 billion proposal. Nearly half of the money — $10.4 billion — will go toward the so-called loss carry-back extension, which will allow businesses, both large and small, to apply any losses suffered in 2008 and 2009 to income made in the previous five years, three years longer than current law allows. The result will be tax refunds topping $33 billion next year, according to the Joint Committee on Taxation.

Yet another amendment, to extend a popular $8,000 tax credit for new homebuyers, will cost $10.8 billion over a decade, JCT estimated.

Supporters of the two tax breaks — including Senate Majority Leader Harry Reid (D-Nev.) and Senate Finance Committee Chairman Max Baucus (D-Mont.), the bill sponsors — argue that they’ll help prop up businesses in the midst of the worst unemployment crisis in 26 years.

Yet an analysis of a similar bill by Mark Zandi, chief economist at Moody’s Economy.com, indicates that, in terms of bang-for-the-buck, the lopsided allocations in the stimulus bill are dubious. Indeed, for every dollar spent on the business tax rebate, just 21 cents are returned to the larger economy, according to Zandi. By contrast, the homebuyer tax credit returns 90 cents on the dollar, he found, while the unemployment extension returns $1.61.

Heidi Shierholz, economist at the liberal Economic Policy Institute, said that there’s “no economic rationale” for the business tax rebate. “For whatever reason that [provision] got in there,” she said, “it has nothing to do with stimulating the economy.”

At the start of the debate, it wasn’t in there. Indeed, when the House passed its unemployment extension bill in September, the $1.2 billion proposal stood alone. It was in the Senate, after weeks of delay over controversial amendments, that Democratic leaders decided to sweeten the pot by adding the two tax breaks. Leading up to the upper-chamber vote, Sen. Tom Harkin (D-Iowa) explained the Democrats’ position.

“The two were put together as a means of greasing the skids,” Harkin told the Huffington Post last week. “You know how things work around here. Could we have gotten UI through otherwise? Yes, we could have, but it would have taken us several days. And we don’t have that kind of time. And the minority is then able to, because of the time, demand certain things.”

Meanwhile, the nation’s unemployment rate jumped to 10.2 percent in October — the first time it’s topped 10 percent since 1983. When those who have stopped looking for work are considered, that number tops 17 percent.

Washington Post business columnist Steven Pearlstein, a Pulitzer Prize winner, said the carry-back provision, far from an effective stimulus strategy, will merely “delay the inevitable downsizing and consolidation of these industries.”

“The perverse effect,” Pearlstein wrote, “will be to reward the companies that failed to pay down debt and squirrel away cash when times were good and, by artificially keeping them alive, punish the competitors that did.”

Even some conservative economists are doubting the stimulating effect of the loss-carry back provision. Desmond Lachmann, economist at the American Enterprise Institute, said the $33 billion spent next year is simply too small, relative to the larger economy, to stimulate much growth.

“We are talking about 0.2 percent of GDP,” he said.

Doggett took a harsher angle, accusing his colleagues of rewarding the very companies that caused the recent downturn.

“This bill,” Doggett said, “now directs the Treasury to essentially write a check directly to corporations for more than $10 billion — checks to corporations that have committed fraud, checks to corporations that have no ability to create jobs because they have no employees and exist solely on paper as a fiction. It rewards some of the very corporate losers who have brought us to the brink of economic ruin.”

No matter. The House passed the bill 403 to 12, with even Doggett voting in favor. The Senate had passed the bill the day before, 98 to 0.

On Friday, President Obama signed the measure into law.

Congress doesn’t know what its next step will be in regulating Wall Street after the financial meltdown. But the House Oversight and Government Reform Committee accomplished an authoritative takedown today of the credit ratings agencies. Through documents obtained by the committee and unusually sharp questions from committee members, we learned this:

• During the housing bubble of 2002-2006, there was virtually no government regulation of the credit-rating agencies. The Securities and Exchange Commission proposed rules in 2002 to monitor them. That’s when bond issuers were securitzing subprime mortgages and collateralized debt obligations at ever increasing rates. By the time Congress finally passed a reform act, it was 2006 and the housing bubble was about to burst.

• The credit-rating agencies were even more tardy in responding to the housing market collapse than the SEC and Congress. Moody’s CEO Raymond McDaniel continually issued reassurances that the mortgage-backed securities and credit default swaps his firm was rating AAA deserved the rating.  Even privately, McDaniel only began to identify the problem in Sept. 2007.

A transcript (pdf) of a Moody’s “town hall” company meeting shows that McDaniel told his employees in September that it was time “to speak as candidly as possible about the subrpime market.” But the discussion mostly centered on “extensive outreach to the media” to disentangle the rating company from the subprime mess.

Just one month later, McDaniel wrote to his board of directors (pdf) that the company’s business model needed to have a “careful postmortem” evaluation.

• The credit rating agency industry is in tatters. Moody’s has been around for 100 years, but it wasn’t until the late 1970s that the company had to rely on the issuers of bonds for its profits. The obvious conflict of interest– will an issuer come back to a credit-rating agency if the agency unfavorably rates the bond?– finally caught up with the industry in the subprime mortage market.

None of the rating companies developed a credible model to rate mortgage instruments, and there was a race to the bottom to rate risky bundles of subprime loans as AAA.

“In my [Baltimore] district,” said Rep. Elijah Cummings (D-Md.), “students are not able to get loans, businesses are closing and seniors are going back to work. You’ve lost our trust.”

The CEOs didn’t respond to Cummings’ remarks or numerous other accusations that they have lost the public’s trust.

But it was clear that the credibility of an entire financial industry had been destroyed in just five hours.

The panel, and most lawmakers on the committee, seem to agree that the failures of the big three credit-rating agencies — Moody’s, Standard & Poor and Fitch– is about more than just “gross incompetency,” as Rep. Mark Souder (R-Ind.) put it.

Frank Raiter, managing director and head, from 1995-2005, of the Standard and Poor unit that rated residential mortgage-backed securities, said that the credit agency didn’t understand credit default swaps when he was there. “Intuitively, if you can’t explain what these things are to us [people whose job is to evaluate mortgage securities], it was real curious why the product was enjoying financial success.”

Yet S&P, which controls 40 percent of the credit-rating market, routinely gave the swaps AAA ratings. Internal S&P and Moody documents reveal that the companies knew their rating systems were broken but their continued business depended on rating these swaps. One Moody’s memo says that, ideally, investors would come to Moody’s based on “ratings quality” and “service.” But they were actually looking for a AAA rating. And if Moody’s couldn’t deliver, the investor would go to S&P or Fitch.

Sean Egan, managing director of Egan Jones Rating Co., said CRA executives felt compelled to capitalize on the brave new world of swaps. “It’s not incompetence,” he told the committee. “If you are the manager of this public company, it’s your job to increase revenues and profitability.”

The CEO’s of Standard & Poor, Moody’s and Fitch will testify this afternoon.