The Man Who Called the Financial Crisis—70 Years Early - By Jason Zweig

Found via Simoleon Sense.

Decades before anybody had ever heard of a mortgage derivative, an economist named Melchior Palyi predicted key causes of the 2008-2009 financial crisis with precision that makes a modern reader's hair stand on end.

His warnings help explain why investors insist on trusting market gatekeepers they know to be fallible—such as policy makers, regulators and credit-ratings firms.

The seeds of today's problem were planted long ago, and its forgotten history holds important lessons. In 1936, as part of reforms under the new Banking Act, the U.S. government mandated that federally regulated banks could no longer hold securities that weren't rated investment-grade by at least two ratings firms.

To determine how to implement the new policy, the government launched a massive project—with experts from the Federal Deposit Insurance Corp., the National Bureau of Economic Research and the Works Progress Administration—to study how credit ratings should be used.

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."