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93% of 2006 AAA-rated subprime mortgage-backed securities now rated junk

nytimes.com

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Re: 93% of 2006 AAA-rated subprime mortgage-backed securities now rated junk

#41

Post by jimbokun »

btilly wrote: post #13
matasar wrote: post #9

Earlier quoted context omitted.

Maybe investors could pool resources to start their own rating agency that would be answerable to them, and publish ratings for everyone to use? There has to be a better system.

The problem with that is that the ratings are a public good. Public goods have some counter-intuitive properties. Investors would have every incentive to individually contribute as little to the pool as possible as long as action happened. Economic theory says that one of four things is likely to happen. Those are: 1. The knowledge is worthwhile to a small group (often just one) of investors, who fund it. The memorab…

This seems somewhat similar to open source software, where there is also a free rider risk. This has not stopped large corporations from contributing to open source software, because there are often strategic advantages stemming from the software's existence and wide distribution.

I'm not sure how this applies to an investor funded rating agency. I don't know that there is any strategic advantage to large firms having accurate bond ratings publicly available, but it would be interesting to hear business models where there would be.

Re: 93% of 2006 AAA-rated subprime mortgage-backed securities now rated junk

#42

Post by _delirium »

alphaBetaGamma wrote: post #36
WorkerBee wrote: post #19

Earlier quoted context omitted.

but to be fair, these are hugely correlated instruments That makes them more risky, not so? How did they get the AAA rating then?

Yes, all (ex) AAA-rated derivatives of subprime mortgages are highly correlated. No, that (in itself) does not make them more risky. You just do not want to invest %100 of your portfolio in them. E.g. U.S. Government debt is currently AAA rated. But all bonds and treasuries are highly correlated: in five years either 0% or 100% of US Gov debt will still be AAA.

Yeah, it's somewhat similar to weather predictions for nearby areas. If the weather forecast predicts 10% chance of rain for Palo Alto, and the same for East Palo Alto, Mountain View, Atherton, etc., the expected outcome is not that it will rain in exactly 10% of those places. It will probably rain in close to 0% or close to 100% of them.

Re: 93% of 2006 AAA-rated subprime mortgage-backed securities now rated junk

#43

Post by roc »

gvb wrote: post #33
WorkerBee wrote: post #19

Earlier quoted context omitted.

but to be fair, these are hugely correlated instruments That makes them more risky, not so? How did they get the AAA rating then?

By recursion. The initial iteration is that they pool a bunch of loans together to aggregate the risk. They know from history (short term history - a vulnerability that turned into a failure mode) that mortgage defaults are quite unlikely to happen in the first, say 5, years, so they can sell paper that matures in 5 years and be confident that it has a low failure rate from the (flawed) historical perspective. The lo…

Trick is, the ratings agencies knew 1 and 2 were happening; questions about the practice were raised.

That no-one did anything when questions were raised is what brings us back to fraud. The ratings agencies were allowing a known-flawed system to apply known-incorrect ratings because it served their own financial interests.

Re: 93% of 2006 AAA-rated subprime mortgage-backed securities now rated junk

#44

Post by Symmetry »

btilly wrote: post #5

When people say they will act one way and have financial incentives to act another, expect them to follow the financial incentives. Appropriate regulation can help for a bit. But unfortunately the regulated party has incentives to provide incentives (such as contributions to political campaigns) to gain control of the regulations. This leads to regulatory capture that then renders the regulations ineffective. In a pe…

Whats that economics law that says something like "Once pressure is put upon an observed regularity in the markets for control purposes it tends to disappear"? When buyers only cared about the truth of a rating they had a pretty good reason to want the ratings to be as accurate as possible (counteracting the seller's incentives). But as soon as reserve requirements are dependent on how what the credit rating says suddenly both the buyer and the seller have an incentive for things to be rated as highly as possible.

Re: 93% of 2006 AAA-rated subprime mortgage-backed securities now rated junk

#45

Post by goatforce5 »

akronim wrote: post #25
Alex3917 wrote: post #2

Headline is inaccurate, it's 93% of subprime-backed mortgage securities.

Exactly - the majority of AAA bonds would be US/Euro/Sterling government bonds, which are still AAA rated.

Greek bonds aren't doing so hot right now:

"The ratings agency, Standard & Poor’s, downgraded Greece’s long-term and short-term debt to noninvestment-grade status and cautioned that investors who bought Greek bonds faced dwindling chances of getting their money back if Greece defaulted or went through a debt restructuring. Earlier, S.& P. reduced Portugal’s credit rating and warned that more downgrades were possible."

http://www.nytimes.com/2010/04/28/business/28markets.html?sr...

There was an NPR Planet Money podcast recently that said if Greece failed, others were likely to follow:

http://en.wikipedia.org/wiki/PIIGS

http://www.npr.org/blogs/money/2010/02/podcast_yes_greece_co...

Re: 93% of 2006 AAA-rated subprime mortgage-backed securities now rated junk

#46

Post by sgoraya »

Alex3917 wrote: post #2

Headline is inaccurate, it's 93% of subprime-backed mortgage securities.

I would highly recommend the book, The big short by Michael Lewis. It really exposes how subprime-backed mortgage securities were developed and the credit default swaps that insured them. The story of Michael Burry, silicon valley founder of Scion Capital, who shorted the subprime market was very interesting.

Re: 93% of 2006 AAA-rated subprime mortgage-backed securities now rated junk

#47

Post by aac74 »

pauldino wrote: post #40
aac74 wrote: post #23

Earlier quoted context omitted.

The way I read it is that Krugman is quoting someone to support his argument for ultra low interest rates. Krugman like all Keynesians thinks bubble booms are good and recessions are bad. He fails to mention the artificial carry trade in gold that central banks set up in the 90s to push gold prices down and stock prices up. Central banks at this time also promoted derivatives to create the illusion of low inflation b…

Who prints their money? The US Treasury, literally. Panama has pegged its currency 1:1 to the US dollar since independence and doesn't even bother printing its own paper money, using US notes instead.

Unlike the US dollars/balboas in Panama are not printed out of thin air. Panama has to do productive work in order to earn dollars and thus the money supply can not race ahead of the productive capacity of the economy. This is why Panama has never had an inflation problem (unlike the rest of Latin America) and has short periods of deflation.

Re: 93% of 2006 AAA-rated subprime mortgage-backed securities now rated junk

#49

Post by btilly »

RyanMcGreal wrote: post #30
btilly wrote: post #5

When people say they will act one way and have financial incentives to act another, expect them to follow the financial incentives. Appropriate regulation can help for a bit. But unfortunately the regulated party has incentives to provide incentives (such as contributions to political campaigns) to gain control of the regulations. This leads to regulatory capture that then renders the regulations ineffective. In a pe…

Effective regulations are those regulations that change the balance of incentives to remove moral hazards and internalize externalities.

That is true. But the organizations that have been forced to internalize externalities have a strong desire to externalize them again. And will try to change the regulations to allow them to do so. Success is generally a question of when, not if.

As an example we averaged one credit crisis per decade for over a hundred years. Then Depression era regulations such as Glass-Steagall put an end to that for several decades. The regulations were eroded then finally removed, and a decade later we had a credit crisis. The Depression era regulations succeeded. But a later generation came to believe that the threat they were blocking was hollow, and the regulations changed.

Re: 93% of 2006 AAA-rated subprime mortgage-backed securities now rated junk

#50

Post by btilly »

jimbokun wrote: post #41
btilly wrote: post #13

Earlier quoted context omitted.

The problem with that is that the ratings are a public good. Public goods have some counter-intuitive properties. Investors would have every incentive to individually contribute as little to the pool as possible as long as action happened. Economic theory says that one of four things is likely to happen. Those are: 1. The knowledge is worthwhile to a small group (often just one) of investors, who fund it. The memorab…

This seems somewhat similar to open source software, where there is also a free rider risk. This has not stopped large corporations from contributing to open source software, because there are often strategic advantages stemming from the software's existence and wide distribution. I'm not sure how this applies to an investor funded rating agency. I don't know that there is any strategic advantage to large firms havin…

Open source is an interesting example.

Normally there are transaction barriers that inhibit cooperation in providing public goods. However software has far fewer of those barriers. And so you get a situation where a network of loosely connected people each pursuing individual goals can collectively provision a public good.

I remember running across a footnote in The Logic of Collective Action saying that this was a theoretical possibility, but no example was known of it. (The book was written back in the 1960s.) In any case it is an extremely unusual example.

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