As the great credit crisis of 2007-2008 finally begins to lose steam, most people still don’t understand what the heck happened. For good reason. It’s confusing stuff. The terminology is complicated. The people aren’t well known. The pieces move around quickly.

To the rescue comes Roger Lowenstein, author of When Genius Failed and, significantly, a fine article in this past weekend’s New York Times Magazine. In a nutshell, Lowenstein explains methodically, and in some of the simplest declarative sentences you’ll find written in business journalism, how conflicts of interest at the credit-rating agencies — Moody’s (MCO), S&P (MHP) and Fitch — misled investors in mortgage-backed securities.

The conflict is straightforward, and I’ve written about it here before: The agencies make most of their money from fees paid by bond issuers and their banks rather than from the investors who rely on the ratings. Lowenstein neatly dismisses the credit agencies’ explanation that they did the best they could with the information they had at their disposal. In a pivotal passage, Moody’s walks readers through an actual portfolio of subprime mortgages that was packaged by an investment bank and rated by Moody’s. The actual names are obscured as “Subprime XYZ,” which is how Moody’s was willing to share the illustrative example with Lowenstein. Consider this passage:

The loans in Subprime XYZ were issued in early spring 2006 — what would turn out to be the peak of the boom. They were originated by a West Coast company that Moody’s identified as a “nonbank lender.” Traditionally, people have gotten their mortgages from banks, but in recent years, new types of lenders peddling sexier products grabbed an increasing share of the market. This particular lender took the loans it made to a New York investment bank; the bank designed an investment vehicle and brought the package to Moody’s.

Moody’s assigned an analyst to evaluate the package, subject to review by a committee. The investment bank provided an enormous spreadsheet chock with data on the borrowers’ credit histories and much else that might, at very least, have given Moody’s pause. Three-quarters of the borrowers had adjustable-rate mortgages, or ARMs — “teaser” loans on which the interest rate could be raised in short order. Since subprime borrowers cannot afford higher rates, they would need to refinance soon. This is a classic sign of a bubble — lending on the belief, or the hope, that new money will bail out the old.

Moody’s learned that almost half of these borrowers — 43 percent — did not provide written verification of their incomes. The data also showed that 12 percent of the mortgages were for properties in Southern California, including a half-percent in a single ZIP code, in Riverside. That suggested a risky degree of concentration.

On the plus side, Moody’s noted, 94 percent of those borrowers with adjustable-rate loans said their mortgages were for primary residences. “That was a comfort feeling,” Robinson said. Historically, people have been slow to abandon their primary homes. When you get into a crunch, she added, “You’ll give up your ski chalet first.”

This shows Moody’s understood full well that the mortgages were all subprime. This means
that, by definition, the mortgage holders had inferior credit, and that a giant percentage didn’t supply documentation to back up their income claims on their mortgage applications. Moody’s and others say they were victims of fraud. Yet they’ve admitted to Lowenstein that they were willing victims of fraud. A final note to Claire Robinson, the veteran Moody’s executive quoted at the end of that passage: People who can’t afford prime mortgages typically don’t have ski chalets.

It’s worth taking a step back here and asking what can be done about the conflict. I met Monday with Bill Hambrecht, the founder of the old Hambrecht & Quist [now part of JPMorgan Chase (JPM)] as well as his current firm, the dutch-auction promoter WR Hambrecht + Co. He told me it’s not simply that the ratings agencies curry favor with the banks. It’s also that the analysts at the agencies, who might make in the neighborhood of $100,000 a year, cozy up to the bankers they meet with because they’re interested in going to work for the banks, where they can earn a lot more money. Hambrecht’s solution: Empower the government to rate bonds, especially if the government requires certain kinds of fund managers to own only officially-rated bonds. Lowenstein, by the way, comes to essentially the same conclusion, though he doesn’t directly advocate a government-run ratings regime.

When Katie Benner and I were reporting an article this summer on the role of the big credit rating agencies in the mortgage-finance crisis I had a weird education on how these firms work. To boil it down, companies that want to sell debt in the public credit markets first present their information to ratings agencies, which then issue ratings and research to investors. The agencies — Moody’s (MCO), S&P and Fitch are the biggest — collect fees from the issuers. In other words, the institutions charged with giving advice to investors make their money primarily from companies issuing debt. It’s a classic conflict of interest, a case of the fox guarding the henhouse. Their fee, by the way, is contingent on the sale, meaning that the agencies are motivated, financially at least, to move the goods, not give good advice.

What interested me over the summer was that whenever I pointed out this conflict to anyone in the debt dodge, they told me this was the way it always worked. Case closed.

Things may be changing.

Hank Paulson, the treasury secretary, addressed the issue in a speech Tuesday, saying: “It is clear that we must examine the role of credit rating agencies, including transparency and potential conflicts of interest. We must also assess if regulations and supervisory policies are encouraging an over-reliance on ratings by financial institutions and investors.”

Well, identifying the problem is a start, but Paulson hardly is offering solutions. You’d think debt investors would be willing to pay for impartial advice, right?