Massively fraudulent credit ratings on mortgage bonds was one of the things if not the thing that precipitated the 2008 housing/economic crisis. Your comment reads like you think bond ratings are mostly accurate but recent history tells us they can't really be trusted.

Yes, massive fraud is one factor that can cause bond defaults to significantly exceed those predicted by credit ratings. Other reasons can include disruptive technology, natural disasters, armed conflict, and other "black swan" events.

What does "priced in" actually mean? A low probability event should be priced in, with the appropriate small but non-zero coefficient. If you get hit by a "black swan event" couldn't you say that your model failed to account for it?

In practice, "black swan" is supposed to mean effects which we underestimate or fail to predict at all. The definition requires not just rarity but an event which hasn't been seen before, and is only only understood in retrospect.

You can try to leave a general hedge for unknowns, like never giving anything >99% long term confidence. But actually pricing black swan problems accurately should be impossible, pretty much by definition.

It just so happens that people, when making predictions, are not very good at accounting for ("pricing on") those kinds of events.

Ha ha. No they (the people who make real deals/trades/decisions) are just focused on their bonus. Having said that they also care a bit about their bonus. And of course their bonus is important too. Have I missed anything?

I think you're mostly comprehensive there. You missed out two things though: they care about their bonus, and secondly, how that bonus compares to their peers (which could be summarised as "their bonus").

After which they blame the "bad model" and immediately pass on to constructing newer, presumably better models. The fact that maybe, just maybe, trying to model such a thing as a modern-day economic system is futile never crossed these people's minds.

You are being unfairly downmoderated. It is of course not a given that modeling economic systems is impossible, but there is considerable debate as to e.g. what degree prices are random/unpredictable. Everyone agrees the problem is extremely difficult, and it seems somewhat unlikely that there would ever be such thing as a universally applicable financial model. So the remaining question is, of course, to what degree are these models useful? I do not believe there is sufficient evidence to reject the idea that the models are of no utility, especially in the context of failing to price in risks. The contrary position is equally viable, and I would hope anyone with what they considered to be a knock-down argument would do more arguing than knocking down.

Fair point, but the whole impetus for this reporting is that Fitch, one of the big 3 ratings agencies, has raised the issue and acknowledged that the full effect of battery technologies exceeds the time frame of their rating methodologies and so they're urging utilities to diversify into clean energy. I know that doesn't absolve them of past sins or even imply that they can be trusted, it just struck me as ironic that a warning from one is the basis of this post and discussion. They're doing their job here.

Less fraud than you might think. It was more the model where house values would increase or level off not crash, which meant worst case was recovering X% vs 100+% where x% would still cover the outstanding loan. Which allows you to slice and dice very low risks loan value from junk, not because most people are going to pay back, but because the houses have high inherent value.

Their scapegoat was the model. In reality they could probably make a model that gave whatever rating the client desired. That is the fraud, they weren't working in the interest of the investors they were working in the interests of the investment bankers.

https://www.youtube.com/watch?v=19amWOc1GJ8

https://www.youtube.com/watch?v=whlzFWwVv98

In any organization whoever pays the bills tends to get what they value - because they can decide to pay someone else if they feel they're not getting it. All the "arms-length", "neutral" stuff - even if truly well intentioned - get impacted by whatever the payer wants.

In case of mortgage bonds, the bill payers were bond creators who wanted to get the loans off their books as quickly as possible. The buyers should really know better but they too were largely managers whose salary was paid on % of assets basis with no real downside impact on their own wealth.

Can you cite evidence of actual fraud in the typical bond rating?

Note: making wrong assumptions (explicitly stated) about the future is not fraud. I.e., "I think housing will never go down" is not fraud.

That's not really how it works either. Bondholders usually trust the ratings agencies (this trust is often mandated by law for pension funds, etc.) which have often basically lied about ratings because they were paid by the issuer.

When challenged on this they usually claim the first amendment (i.e. license to lie), although S&P went a step further and downgraded the US in a fit of rage when the SEC started investigating them for ratings fraud in 2011. Ironically interest rates on US treasuries went slightly down afterwards.

> although S&P went a step further and downgraded the US in a fit of rage when the SEC started investigating them for ratings fraud in 2011.

At the time, the US government was actively considering whether to default on US Treasuries. The downgrade wasn't some petty revenge.

At no point even during the height of Republicans' "government shutdown" was the US government ever actively planning on defaulting on US treasuries.

Their rationale was, in any case, that "entitlements spending" was too high:

https://www.theguardian.com/business/2011/aug/06/sandp-debt-...

The entire rest of the market (and the other ratings agencies) were just about able to determine that if you have the keys to the cash printer you're actually not in danger of running out of cash and political bickering doesn't translate into risk of political suicide.

The white house and congress was deadlocked, the government was shut down, and the treasury was not legally authorized to borrow more to make payments. There was talk of a trillion dollar coin to side step the national debt cap. This was a really big deal, and people were scared the maneuvering wasn't going to work in time. It totally justifies a small credit rating downgrade.

It was pure political theater. Any attempt to actually trigger default would have been political suicide for whomever tried it.

When actual credit events look likely it triggers a sharp rise in interest rates. It looks like this:

https://4.bp.blogspot.com/-9UVV9J6AdU0/TzxG9W26TsI/AAAAAAAAC...

That did not happen. Nothing happened. Not even a blip. The market (correctly) assessed this as being the usual partisan political bickering.

Oh come on. This is partisan hackery. This "theatre" did in fact cause vital government functions to shut down. I was personally on a project where I had to stop work because our checks were sitting on a table in Washington and a major milestone meeting was canceled because the government was furloughed and would not be there, throwing the entire project schedule off. This was replicated thousands of times across the economy.

Even the ghost of a chance of going down to the wire as to whether a bond payment would be missed by a single day on US obligations, is in itself tremendously disruptive. The economy is structured around U.S. debt as being the safest paper there is. Don't downplay just how dangerous dicking around with this for partisan points was.

No, playing up the fearmongering as you are doing right now is partisan hackery. The main Democratic talking points centered around fearmongering, after all, which was almost as stupid as the Republicans temporarily shutting down the postal service, etc. in a fit of pique.

As I said before: the markets correctly characterized the debt ceiling negotiations as a bunch of drama queens on both sides of the political divide acting up & a storm in a teacup because neither side is politically suicidal.

However, a fair number of tea party members in congress were actively promoting defaulting on the debt. That's different than some random guy with a page on the internet. That's a lawmaker with a vote who can affect the outcome. So their political career would be hurt. The election wasn't the next day, it would have taken a long time to replace those yahoos and the damage would have been done. Examples:

Ted Yoho, rep for Florida, http://www.rollingstone.com/politics/news/the-tea-partys-gov...

Trump (who isn't in congress, but had a shot at being president: http://mediamatters.org/research/2016/05/08/media-slam-trump...)

yes, it is nuts, but people who vote in congress supported it, and the pres. candidate of one of our two parties also said that.

Actually, most of the Republican party is in the process of committing political suicide right now. Enough with your vacuous false balance.

You are right sir. And after the ratings agencies downgraded US debt, they actually appreciated in value. Because anyone who understands government finance knows that issuer's of currency cannot default on their own debt instruments unless they want to.

Check out HyperNormalisation by Adam Curtis - should be on interest.

Almost.

Various parties are required to trust that anything rated D or whatever is risky. They aren't required to trust that AAAAAA+ means risk-free.

Excuse me for stating the obvious. Nothing is risk free. Indeed even cash is not risk free.

Right, and nothing on the planet is black, because there always some minor light reflection.

In real life, this sort of sophistry only makes terms like "risk-free" and "black" useless.

Not all bond holders get paid, however one's who bonds support a public pension will get paid. the courts and government have already shown a great disdain for the law (bankruptcy) and will pay one class before another even if the law specified other. Also, tax payers are on the hook for any and all failed bonded backed pensions.

I fully expect that energy companies have already started to diversify and buy into industries that could disrupt their earnings. Good successful corporations know when to move, RJ Reynolds is probably the best example of a company diversifying when its main product started to become a liability.

Private investors and tax payers are the only victims. The first because their investment is gone and the second who has to pay to fix the the public employee pension funds that may have purchased the same bonds which means the first party is actually stung twice

Ultimately, a company has to pay up, or liquidate what it has in order to pay its debts. If it can't do that, then those who hold equity get shafted. That's just a function of the capital structure.

A government uses debt to pay for stuff. If it defaults on its own debt, it hurts its ability to generate funds without printing currency. So if a government defaults, it not only incites domestic panic and foreign wariness of its markets, it also loses the ability to affordably borrow to pay for programs that can right the ship.

Even for companies where bonds are pricing in a substantial probability of default, it's a big deal if they fail to service their debts. Sprint can survive a 30% drop in its stock price. It probably can't survive defaulting on 30% of its debt.

Well, not getting paid is a pretty good incentive to make sure the expected rate of defaults closely approximates the actual rate of defaults. Maybe bondholders ought to try that sometimes.