The horrifying AAA debt-issuance chart
blogs.reuters.com
blogs.reuters.com
The problem, which started becoming visible in 2001, is that in the aftermath of the "dot-com boom", the ratings agencies starting rating a lot of things AAA that were not, in fact, AAA. That is not "an excess of overcaution". In fact it was an exploit of the banking/finance system, that went like this:
-- lots of places are required by law or regulation to only invest in AAA securities, because they/the public don't want to lose any money. They have a LOT of money to invest.
-- but they don't check the shit themselves
-- they depend on a rating agency
-- ratings agencies are paid by the issuers
-- they are exploitable
-- bribe the rating agency to give my shit a AAA rating, and now I can sell a ton of it
-- offer the investor a slightly greater than AAA return, and they love it
-- everyone is happy: rating agency is bribed, investor is getting better returns than expected, and I can sell all the shit I can package up
-- until it all falls apart.
None of this has anything to do with an excess of caution or with AAA debt being more systemically dangerous than other types of debt. The blogger here almost grasps what is wrong:
> "That’s possibly the most horrifying bit of all: it simply defies credulity for anybody to be asked to believe that more than half the bonds issued in any given year are essentially free of any credit risk."
but he skips past the correct answer, which is that the ratings agencies have been suborned.
Specifically, you're misinterpreting what is meant by "an excess of overcaution". Felix is referring to how investor demand being too cautious (i.e. only interested in or able to invest in AAA) lead to a scenario where all sorts of tricks were developed to get an AAA rating on securities [1].
1. http://blogs.reuters.com/felix-salmon/2009/08/26/shrinking-b...
http://finance.yahoo.com/q/bc?s=JNK&t=2y&l=on&z=...
...notice that the 20 year treasury is more volatile than junk bonds.
More apt comparison would be intermediate treasuries, much different picture (time frame also questionable for a pure comparison):
http://etfdb.com/etf/JNK/fundamentals/ http://etfdb.com/etf/IEF/fundamentals/
NIIP is interesting. Despite the US's huge debt, they have a reasonable NIIP of about -25% (I think). So the money is mostly there. It's mostly in private hands, but as long as the private sector is OK, the government will keep collecting taxes.
The obvious problems with the US are its health system (more public funding than countries with free health, but terrible value for money), its military deployments (the military can be an OK if they use it to drive high-tech growth, but actually deploying it very expensive), its prison system (they tend to lock criminals up for a little too long, and they have way too much crime for other reasons).
http://www.moodys.com/sites/products/AboutMoodysRatingsAttac...
Unfortunately the chart only goes back to 1990, and I don't have time to dig up historical figures. Perhaps more financial instruments used to enjoy a AAA rating until the Savings & Loan scandal of the late 80s, and the sudden upward jump in ratings represents the purging of bad assets from the financial system following the recession of the early 90s. But really, I don't know. Without disputing your observations above, I think we could learn a lot from looking at the largest discontinuity here rather than focusing on the absolute volume figures from recent years, notwithstanding the significant increase in securitization following the repeal of Glass-Steagall.
Interestingly, there's now the question of whether the US debt should be rated AAA : Is there more than a 1-in-100 chance that the two sides can't get to some compromise (or, more likely, agree on how to kludge things) by September?
AAA is meant to lead to default at a 1-in-10000 per annum rate (it's a standardized measure). So, by that argument, USA downgrade should have already occurred.
And, since companies cannot be rated higher than the countries that they're in, that would lead to the immediate downgrade of Microsoft, etc...
You seem to be jumping from one conclusion to another which much reasoning to link them, and then drawing another conclusion from that.
There's no such rule. In fact, Japanese companies have been rated higher than Japanese sovereign debt.
http://www.bloomberg.com/news/2011-01-27/toyota-canon-rating...
A lot of the AAA growth from 1990 forward comes from the application of these structures to securitization of non-mortgage consumer loans, first auto and credit card loans, then others.
Proliferation of "credit enhancements" certainly did spark the AAA bubble, but I'm quite certain that participating financial institutions became much more profitable under this new regulatory regime.
Specifically, the deregulation of OTC derivatives[1] in 2000, which allowed issuers to purchase insurance against loss, caused massive growth in AAA ratings for ABS (dark purple section). In fact, there is an excellent Frontline piece on the story[2].
[1] http://en.wikipedia.org/wiki/Commodity_Futures_Modernization...
One other factor (from the early 90's, I think), was when getting asset sale treatment for GAAP and RAP (bank regulatory accounting) while still getting debt for tax treatment become standardized. That was a breakthrough.
I thought we established a long time ago that the ratings system is broken, this is just another symptom of that illness that no one is willing to even try to cure.
* The finance industry engineers new ways to massage riskier debt into AAA products
* The market eagerly devours all the new AAA debt, building new business models and expanding previous ones based on the increased availability of risk-free products, thus
* Sparking demand for more AAA debt.
"As it turned out, triple-A-rated mortgage bonds stuffed with bad subprime mortgages were considered very low risk" Source: http://www.nytimes.com/2011/07/10/magazine/sheila-bairs-exit...
Anyway, seems to be a business opportunity to start issue ratings for AAA papers, as obviously there is a lot of junk AAA out there.
Now, a lower rating would result in a hirer interest, as lower ratings means higher risk (at least in theory, but what this article actually shows is that this isn't the case).
Mind you, despite all this you can have a serious news piece of "someone from Moody's" claiming that they might be forced to lower the US' rating http://www.bbc.co.uk/news/business-14142621 - which frankly just sounds all kinds of ridiculous.
Also, the US owes money in currencies other than $, which the Treasury doesn't have the power to print.
edit: Now that I think about, it isn't. They have inflation-indexed bonds as well. The more they print money, they bigger their debt grows!
http://www.treasurydirect.gov/indiv/products/prod_tips_glanc...
But the currency markets would not be so easily fooled.
Considering that tbills are issued with "the full faith and credit" of the United States and that it's against the US Constitution to default on them, the agencies have historically rated the debt as AAA.
And yes, technically, the US could not default and still pay back worthless bonds by deliberately hyper-inflating the currency.
Doing so would also make worthless all of the private debts demoninated in US Dollars and effectively destroy the US Economy.
While it's certainly possible that could happen, it's quite remote. Quite.
You would be correct if they held debts denominated in other currencies, like virtually every other country in the planet.
I did not check this, but Zimbabwe definitely did not have an AAA rating in, say, 2008.
The point is that the US treasury will pay its debt. The value of the dollar simply a different question.
By your argument (and apparently, some of the rating agencies'), a supposedly necessary downgrading of treasure bonds would require the downgrade of every existing dollar denominated bond in the world - ie, nearly every AAA bond. Oddly enough, Moody's isn't threatening to do this.
For those who don't understand what's the problem with inflation so long as the bond is repaid, imagine you buy a 10-year, $1,000,000 dollar bond paying 10% interest from the Weimar Republic in 1918. You get $100,000 per year. By 1923 the Mark is worth a trillion times less than it was when you bought your bond, so the resale value is now the 1918 equivalent of $.000001 and the annual interest income is $.0000001. You complain about this to your friend, and he points out that Weimar is still rated AAA because they obviously can print an infinite amount of money to meet their obligations. Do you feel consoled? What kind of interest rate would you require to consider buying another bond?
The United States most likely won't see this kind of inflation because it doesn't have the problems Germany had, but it could certainly see enough to drop the rating to a low A if things really got out of hand.
I'm not saying the probability is big, but is 1% an unbelievable number? Just for reference, back in 2000 what odds would you have put on the US electing a black president before 2050? Back then, I thought that number was very close to zero.
I'm (obviously) not an analyst. I'm baffled at how they can predict return with much confidence 10 years out.
Is there a term analogous to "regulatory capture", for capture of non-government organizations like rating agencies by the subjects of their ratings?
This graph is linear, so it makes it look like the jump from 4000 to 8000 is more significant than the jump from 1000 to 2000, but actually it's not. It's identical.
The only thing they have in common is that both amounts have doubled, but I think there is a huge difference between 1000 to 2000 with 1 million to 2 million although they both have only doubled.
The change from 1 million to 2 million is much more important than the change from 99 million to 100 million.
Try an experiment: take a calculator or a spreadsheet. In one case start with 1000 then keep doubling it. In the other start with 1 million and keep adding 1 million.
A log scale would let you see more detail in the 90s, but in this case I think I actually prefer the linear, 0-anchored version.
As the author rightly points out: we have too many groups requiring AAA-rated securities and not enough real AAA stuff to go around, so most of the AAA ratings are going to be unreliable.
I believe that this is what is happening, but the argument that demand for AAA securities by overcautious investors is the root of the issue makes it sound like all of our problems could have been avoided by curtailing the demand itself- in this case, by encouraging investors to take on more risk (don't be overcautious!) and be willing to purchase lower-quality securities.
As an investor, shouldn't I be able to choose what level of risk I'm willing to accept? And isn't it the job of rating agencies to provide accurate information so I that I can make an informed decision as to the level of risk I'm taking?
"They breed complacency and regulatory arbitrage, and they are a key ingredient in the cause of all big crises, which is leverage."
Is the author arguing that these should all just be rated below AAA and as such be accompanied with higher interest rates? This would obviously depress the rate of issuance because companies would be less inclined to take the terms (at least in theory). This makes sense to me, but doesn't necessarily indicate that AAA rated bonds inherently have systemic risk as the author states.
Perhaps I'll read the article a second time through.
Then look at the green line. Triple-A debt wasn’t a huge part of the bond market back in the early 90s, but for the past decade it has invariably accounted for somewhere between 50% and 60% of total global fixed income issuance. That’s possibly the most horrifying bit of all: it simply defies credulity for anybody to be asked to believe that more than half the bonds issued in any given year are essentially free of any credit risk.
That seems like the nut. It's prima facie obvious that much of what is called AAA can't be AAA; it almost mathematically beggars the definition of AAA.
Meanwhile, all kinds of contracts, regulations, and instruments rely on AAA ratings to prevent money that can't reasonably be put at risk from going into e.g. mortgage bonds.
"it wasn’t an excess of greed and speculation which led to the financial crisis, but rather an excess of overcaution"
The greed then exists in alternate areas of the system. It isn't AAA bonds that are the issue, it is the fact that lesser bonds are being rated as AAA. Why are they being rated that way? The ratings companies have conflicts of interest and were... (wait for it) greedy.
In addition, calling this an "excess of overcaution" is laughable, if I can get decent returns from a "risk free" investment, that isn't cautious, it is logical.
I guess I agree but the thing is that "greed" and "over-caution" actually very similar. Over-caution is greed for income without risk.
For example, Bernie Madoff's appeal wasn't based on offering income level that no mutual fund could match but rather offering an apparent combination of income and stability that no mutual fund could match (10%/year as reported each quarter).
"it wasn’t an excess of greed ..., but rather an excess of overcaution"
I disagree with this statement, and clearly, based on your definition here, this can't be true either. Unless, saying "is wasn't greed it was greed" actually makes sense. Obviously I don't think you believe that, I'm just pointing out a major issue with the article as a whole.
After calling it 'excess of overcaution' he declared that it is leverage that causes crises. Leverage does not connect strongly with caution to me.
There are funds which can only invest in AAA type securities, think pension funds which have contractual obligations far in the future to provide money.
When these AAA instruments blow up, they will take down pension funds which will cash out their equities to rebalance their holdings which will cause a market crash that made 2009 look like a minor correction, which will, in all likelyhood throw us into a deep deep depression because rating agencies will have lost so much credibility that they won't be believed and governments won't have any way to raise funds to 'bail out' their economies.
Kind of a scary thing to think about.
No, but there is a theorem -- or call it an axiom -- that the amount of debt issued is equal to the amount of debt owed... okay, not a theorem, it depends on people being honest. Now the thing that's hard to believe is that we went from a situation in which the vast majority of debtors were unreliable to the current situation where a significant proportion are considered reliable, and did all of this without any really significant or obvious cultural change, and during a period in which bankruptcy was just as common as before... basically, the "mathematically impossible" thing is that there is a lot more debt being considered reliable but there aren't any more reliable debtors.
Now, you could contest the latter: are there more reliable debtors today? It's not impossible, but I don't see very many, beyond the US Treasury.
Suppose I created a security that would give me back all the loose change found on the streets of Manhattan at any one instant. How much is that worth - $5, $20, more? (there's a lot of streets, and I'm always surprised how often I find a coin).
But I can guarantee that it's worth at least $1.00. That would be a AAA risk. And Moody's would rate it so, just by looking at the statistical properties of coins * streets.
This adds 1 security to the totals. The 'new idea' is that investors were willing to invest in new 'slices' of existing pools - chosen so that they'd get a AAA rating.
The idea itself isn't bogus. But the historical statistics of the subprime market were not valid for the wave of 'new money' moving into the Florida & Vegas markets... Subprime mortgages were a different animal than the rating agencies modeled, and no-one had any incentive to call them out on it.
There is a population of bond investments, the risk to the principle in those investments is scored by a rating agency on a scale from D to AAA [1]. The market prices bonds using a combination of risk (as reported by a rating agency) and desired return. (Return is the independent variable). Economic theory says that the quantity of a good demanded influences the quantity supplied such that prices rise until there are no more buyers who will pay more and no more sellers who will offer for less. This relationship between risk and return manifests itself as a spectrum of bond offerings from those with low risk (AAA) and low return (< 2%) to those with high risk (D, aka 'junk bonds') and a high return (> 9%). [2]
It was with this understanding that I used the term 'mathematically impossible' when I was thinking 'the chances that there more AAA bonds in the population of all bond offerings than all the sub-AAA rated bonds put together, is astronomically slim.' For example, California's general obligation bonds are only rated at "A+" (up from BBB but still far from AAA). [3]
It could be legitimate, but were that the case the return on non-AAA bonds would be news because that would be the only way people would buy them. Since I'm not seeing offers for C and D grade bonds with 25 and 30% rates of return (and for some reason those folks seek me out and cold call me) I believe the simpler explanation which is that some portion of the bonds that are rated AAA don't deserve that rating (i.e. they are riskier than they purport to be).
And that, combined with some of the structural ways in which capital is managed in the world, makes for a much more explosive combination than we might otherwise be expecting.
[1] http://www.investopedia.com/articles/03/102203.asp#axzz1SD85...
[2] "Investors have been snapping up the new non-investment-grade bonds, having grown frustrated with stocks and with the meager yields on safer government and high-grade corporate bonds." http://online.wsj.com/article/SB1000142405274870396000457542...
Suppose a typical student is has around $50 in their wallet at any one time : Demanding $50 from a student is pretty risky, and so is demanding $25. But if I have a large enough room full of students (say 100), demanding $2500 from the room (which on average holds $5000) is much less risky than requiring $25 from each person.
That's how AAA securities can be built from bad credits : Not everyone goes bad at the same time.
So the argument should not be about how crazy the idea of bad credits allowing the creation of good credits. The argument is about correlation coefficients.
Moodys / S&P / Fitch got the correlation coefficients between subprime borrowers completely wrong, because they believed that house prices could not all simultaneously decline in the US. And the investment banks had no incentive to explain the errors of their ways to them - and people who weren't "On-Side" at the rating agencies were relegated to lower-growth areas. And the regulators had no clue.
And here we are.
When you AAA a product built out of supposedly uncorrelated risks that turns out to be correlated, you're fucked.
So, to extend your analogy: suppose you designed instruments backed by $5 debts from college students. And suppose as time goes on, Ivy League students used it less and less, while at UMich-Flint the program spread like wildfire. At some point, without even changing the explicit structure of your instrument, basic market forces might up converging on highly correlated (and very risky) buckets of risk, mispriced at AAA (or whatever).
And all the while, every incentive is set up to get people to throw away unfavorable results and cherry pick the most lucrative interpretations.
My point (you are by this point I am sure exasperated with me) is that ratings agencies and product designers are trying to build models to assign risks to quickly moving targets, by taking a spot measurement of the current correlation coefficients and extrapolating them.
Whereas on the other hand the credit history and business model backing BRK is (relatively) straightforward.
The basic error with CBOs is that the rating agencies allowed the structures additional diversity 'points' for investing in different sectors (a decent idea), but then segmented the market so that many, many different telecom-related businesses got put in different sectors. The telecoms bubble then proceeded to wipe out about half the contents of each CBO. Why didn't anyone point out the problem? Because the investment banks, having been given the published specification of how the Rating Agencies would model any hypothetical structure, went about optimizing the portfolios of bonds to maximize the 'ratings arbitrage' available.
Your point about migration of the underlying risks is spot-on. The rating agencies looked at the historical performance of each of the classes of risk. For CBOs, once people saw how the rating agencies would give them points for particular sorts of High Yield bonds, suddenly telecoms (& fibre, & cable, & satellite, & etc..) companies found it very easy to raise what were known in the market as 'CBO bonds' : bonds that no rational investor would want, but would be very appealing for a structure to buy (since it would help its ratios).
Similarly, once there were evening classes in how to improve your FICO score, the whole history of sub-prime borrower repayment statistics became irrelevant. The manipulation of the fundamental inputs to the models by 'good hardworking Americans' was rampant... But the Rating Agencies were being paid well to continue to rate structures (at a crazy pace), and the Investment Banks were in no hurry to point out that the models should be harsher.
Part of the whole problem, though, stems from banking & insurance regulations that mean that its very cheap (from an equity capital point of view) to leverage up AAA paper. That's what drove everyone to demand AAA paper in the first place. And the AAA designations is/was handed out by rating agencies that now claim it was 'free speech' and they're not liable for anything.
As for the moving target aspect : Investment Banks are continually trying to innovate, since that's where it's less competitive, and the margins haven't been competed away. They would ask Rating Agencies to look at new products all the time. If all the Ratings Agencies were too conservative (or cautious), then the product wouldn't work, and would be abandoned. However, if one of them could be persuaded to come up with an exploitable methodology, then they would get all the business...
And before anyone says : Ahh, Wall Street is just about the exploitation of loopholes, think about examples from hacker-space : SEO comes to mind...
[1] except for the example of BRK : That's a bit of a special business. Reinsurance is a tricky thing, and it's possible to look very smart until you discover you're an idiot. AXA looked pretty smart, until... Better examples would be AAA industrial businesses, or a hard-asset business, for instance.
You have 100 million. Now you can put it into a bank, but there is no FDIC for banks so AAA security's are basicly the safest place to put that money. You now look for someone selling safe debt and don't really care about intrest rates just AAA. Banker notices this demand and sells AAA debt from a pool of AA grade debt and get's to keep the intrest as long as a rating agency is willing to certify his bonds as AAA. But how do you satisfy the new demand for AA debt, well a slightly larger pool of A debt can quickly become AA debt etc. But wait if I can take A to AA then AA to AAA why not save some paper work and make AAA from A.
After a while demand for AAA debt is satisfied with large amounts of what amounted to junk bonds and rediculus amounts of leverage. And that huge flow of money went directly to people and institutions that spent it, which stimulated the economy and make it like this where far more stable than they actually where. Meanwhile the people that bought the bonds in the first place now have even more money because the economy is doing great!!!, or atleast it looks that way.
This is tightly correlated with the problem of credit default swaps. At their core, a CDS is an insurance policy. You pay me a premium every year. If the insured bond defaults, I'll pay you out.
Well, if I'm insuring a AAA bond, or the AAA tranche of a bond, I can call that risk-free insurance. IOW, I can call the premiums I'm earning to be risk-free profit.
http://www.nakedcapitalism.com/2011/07/felix-salmon-misreads...
A lot of regulation tells big often state-based institutional investors like retirement plans and university funds that they have to invest X% in AAA rated investments.
Demand for AAA rated products creates not just financial wizardry that spawns more AAA products from riskier products, but the increasingly powerful finance industry/lobbyists pressure government officials (usually appointed representatives from the finance industry) to make this easier...if not transparent.
His point was about the prevalence of AAA-rated products, not their existence.
1. War on Terror and TARP are large portion of the current USA deficit, probably 80% or higher.
2. Over-issuance of AAA ratings will come back to bite as it has to be rolled-over at some point.
3. TARP spending direct result of not controlling the security class known as derivatives ...precedent last time we had to assert Federal control to correct market excesses in securities as 1929-1930 with the SEC act. IN other words we could force security exchanges to outlaw derivatives to bring order/stability back but anyone receiving bank lobby money will not broach that subject.
TARP is expect to cost the taxpayers, $25 billion. A small price to pay to avert total financial ruin.
We could also discuss whether it is a good idea to subsidize the losses of some parts of the financial and automotive industries but not others, whether this is really conducive to a healthy economy based on competition, and whether the incentive structure created by handing bags of stolen money to anyone who can credibly threaten to damage the economy is a good one, but this probably isn't the place to do it.
I think if there was a graph of government debt it would show a big spike around 2008.