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.
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.
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.
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.
"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.
After calling it 'excess of overcaution' he declared that it is leverage that causes crises. Leverage does not connect strongly with caution to me.
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.
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.
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.
"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.