(*Talking Points Memo *is center lefty site, but has the link to the originial story on *Bloombergs/I]…)
Experts Question Ratings After S&P Gives Subprime Bonds Higher Rating Than U.S. Debt
First reaction, what the fuck? Second reaction: skullduggery and treachery! Third, no, no need for that, stupid and greedy will suffice, once again…
But I don’t get it. Not that I have deep expertise in the Dark Arts of Finance, but neither did I just fall off the turnip truck. Which suggests there is another side to the story, a premise for debate. Or, a quick ticket to Pitburg.
Does this, for instance, mean that fiduciary agents who are constrained to only invest, say, pension funds in triple-AAA rated stuff, they are free to dump money into the shit pit? Would they want to? And who the hell are these people, and why do they still have jobs? Other than license plate manufacture, for which they are eminently qualified…
Well, the point of constructing the derivatives was so you didn’t have to buy the whole mortgage, just the first year or two that was a safe bet. That’s why they built the securities out of variable-rate mortgages, so that even a NINJA could make the monthly payments at least for a little while, and once it comes time to actually pay down the debt, who cares?
Now, selling a mortgage like that is stupid, and selling thousands of them is a thousand times stupider. But the first years of each one of those mortgages, bundled together, is a slam-dunk AAA investment that just happens to produce trillions of dollars of financial toxic waste. So the securities they’re rating could very well be AAA, even if the debt used to make them was not.
At the risk of pointing out the obvious, it was the decision to give an AAA rating to these bonds that in large part CAUSED the financial meltdown. So in fact, Nicolas, they simply were not a slam dunk. They failed spectacularly.
Look, I am no socialist; I am firmly capitalist. But not everything about our financial system is perfect. And the evidence is piled to the moon that the rating agencies are full of shit. You can find 25 book-length accounts of the fiscal meltdown that explain that S&P, Moody’s and whatever the other agency is really did not have a clue what the hell they were rating, and by all accounts were rating things based on the fact that they were pressured to take them from the investment banks.
I don’t think people understand that S&P is not some sort of authorized or semi-governmental agency; it’s just another Wall street firm, and they are paid by the banks for rate these bonds. There’s no independence here; they rated colossally risky subprime CDOs triple-A because they were paid to do so. And they’re doing it now.
The AAA ratings for subprime mortgage bonds were simply, unquestionably wrong before, and there is no reason to believe the ratings agencies are any more competent now. The idea that the bonds are equivalent to a Canadian treasury bond is a total joke. No person can make that argument with a sound mind and a straight face.
Giving the AAA rating to the bundling was dependent on the independence of their risk. The chance of a given loan going bad was small.
Unfortunately, those risks weren’t actually independent – they were structurally related and a downturn in the economy and overall housing prices could make a very large number all go bad at once.
Today’s houses are being purchased at their devalued rate so the paper has the appropriate hard asset to back it up. Treasury debt comes with the ability to tax but it also has a great deal of debt attached to it. The ability to tax becomes less secure as the debt ratio climbs.
This is a very key point that applied even more to the credit derivative market that brought down AIG. Unlike insuring ships at sea, whose sinkings are independent, insurances against economic downturn are correlated. Yet this simple fact was lost on the Ferrari-driving geniuses running Wall Street. Indeed a few Nobel-Prize winning economists got so infatuated with their mathematical formulae that they managed to overlook this as well.
But I do not write geniuses with quotation marks. In most cases, the Ferrari-driving geniuses are still driving their Ferraris, thanks in part to the generosity of the American taxpayer.
That word “appropriate”? You can verify this by independent sources, or are you taking someone’s word for it? Certainly I would accept that having a “hard” asset to back a security is “appropriate”, but is it sufficient as well? I have a rather nice doublewide, I might issue a security valued at one million dollars, and have this “hard asset” to back it.
Also, offered an opportunity for a juvenile and crude jest over the term “hard asset”, I have refrained in the interests of propriety and dignity. Let that be noted, for the record.
Not so much a point as a question. I can take the statement at face value, but unfortunately it has two face values. There is one, the painfully obvious, that a security is rendered more valuable and trustworthy if it has a “hard asset” supporting it, tres duh! Certainly, that falls under the meaning of “appropriate”.
Or, it could be taken to mean that all the dross has been removed, all the air let out of the balloon, and the valuation of the asset is firm. The house was valued at $300,000 but it cannot be sold for more than $50,000. So, now this new! improved! security values it at $50K. And so the “appropriate” valuation has been reached. All well and good, but when did this happen? And who decided that the “appropriate” valuation had been clarified?
We have, as a nation, been royally buggered, to a degree that would make the ransom of emperors mere chump change. Like Scottish sheep, we are wise to be wary at the sound of zippers.
OK, chill. The subprime meltdown caused jack squat. It may have been somewhat more hurtful than other possibilities, but it didn’t cause the financial or economic problems. Moreover, the ratings were probably correctly given: absent a massive and more-or-less unpredictable housing crash, they would have been good ivnestments. Only the huge and sudden fall in housing prices in the hottest markets could have driven that down, and there’re few ways to account for that kind of risk.
Subprime problems were symptoms, not the cause, and if they’d never been invented the same money would likely have wound up invested indirectly in housing anyway. There were way too many people, from elected officials to quasi-government agencies (FMA, FMC) to bankers who wanted to flood that market with cash.
I was prepared to give a pass to S&P assuming that there was some misunderstanding of how these bonds are generated. I know it has been covered before, but some of these should be extremely safe and deserve a high rating.
For example, say the bank buys up 10,000 risky mortgages. They bundle them together and create a series of 100 levels of bond from them with different risks and returns. For the highest returns you run a huge risk and even a single default will effect your bond. For the lowest return slice, you will not be affected until 9901 loans default. Even high risk loans don’t have a 99% default rate.*
But when I look at the article, they are giving AAA not to the top 1%, or even the top 10%, but to the top 59%. That seems ridiculous.
*In my opinion, there should be no problem with this type of bonding, as long as risk can be properly assessed. But besides just straight up inflating grades, the rating firms allowed the banks to take the low rating slices and bundle those together and somehow com up with some AAA bonds out of that. Then repeat, until you have AAA ratings on bonds based on the bottom 1% of the bottom 1% of the bottom 1% of multiple pools of these high risk mortgages.
The banks are fighting hard to keep the home values up. When they renegotiate a mortgage, it is with interest rates while retaining the home price. The banks want the unrealistic prices on their books because they are listed as assets, and make them appear more solvent than they are. It is also how bonuses and salaries are rewarded.
The banks are less solvent than they pretend.
I read a story about Vulture Funds being ready to buy up large groups of the mortgages from our banks. They would like them rated at AAA.
I’m probably trying your patience, Stassia, but my ignorance is genuine, and is not a veil for some snark. I don’t get it. Every time I look at this stuff, something new pops out. Usually, ugly.
I understand the bundling part. You put together a bunch of mortgages, and sell a security based on the value of those mortgages, which varies. Clearly, if less solid and reliable mortgages are substituted, the real value of the security must suffer. Got it. Two plus two, four. With you so far.
But does this substitution only take place on securities that are yet to be offered? Shirley, they cannot alter a security you have already purchased without your consent? Perhaps I overestimate the significance, or have simply misunderstood the bleeding obvious.
But the ratings were wrong. That is a matter of historical fact; it is not a debatable point. If ONE CDO had gone under you could argue that the ratings were reasonable, but they all went under. They were simply wrong.
And in fact, the housing crash was not unpredictable; it was predicted by many people who didn’t have a vasted interest in propping the bubble up. Indeed, as has been noted in a variety of sources, the people who shorted the market knew that the so-called AAA subprime bonds would probably fail even without a crash; they just had to have property value climb slowly.
I am not a finance guy, so bear with me.
Investment banks created these bundled bonds by buying up assets (such as mortgages) and holding them. Then they sell bonds based on them. The bank collects the payments, then divides it up among the bond holders. You could theoretically do that with any other type of income yielding asset, including other bonds.
As I understand it, there were bundles of bundles going on. You bundle up and then divide it by group. So the A group gets paid as long as, for example, at least 10% of the loans in the bundle pay out (an 89% default rate does not hurt them). It is not any specific 10%, but these bonds get paid out as long as any 10% of the pool are making their payments. The Z group on the other hand, will stop getting paid as soon as the first 10% default. In return for this risk they get a bigger payout as long as everything is good. So far, so good as long as all risks are on the table.
But say you are a bank who does this and you are having a hard time selling those Z bonds. So, you take all the Z bonds from this bundle, and bundle them with a bunch of Z bonds from other bundles, bundle them all together and slice again (call these second level bonds). Now the A’ group gets paid as long as any 10% of the underlying Z bonds are paying. And those Z’ bonds stop paying when 10% of the Z bonds stop paying. You have just distilled the risk. The A’ used to still get a AAA rating even though none of the assets they were based on could get get that rating.
The big problem with this is that no one really knows what the risk is. Because of that no one knows what an A’‘’ bond is really worth. Those bonds are assets on the balance sheets of banks that counts towards how much capital is required to keep in relation to how much debt it can take on. No one wanted to sell the bonds because if they could only get 10 cents on the dollar they would take massive losses and couldn’t borrow as much. But if they held them, they say they hadn’t lost any value. This is part of what caused the liquidity crisis.
Anyway, it all gets very intertwined and convoluted as the finance sector tried to figure out how to make more money from money instead of actually financing real production. Related comic.
On preview, I think I misunderstood your question. No there is no substitution, but if you buy a $1000 bond from $10,000,000 bundle made up of $100,000 mortgages, you do not buy a chunk of a specific mortgage. The top slice gets paid something as long as any of the mortgages are paid. And if your slice is the top 10%, you get paid as long as any 10 of the underlying loans are good.