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.
And the far right side of the chart is just a continuance of the same thing: our shit fell apart, what should we do? Well, the easiest thing is to bribe the politicians to take our private debts and turn them into public debts. And so it happened. That big tall lavender bar in 2009 is the dark purple lines from a few years prior....
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.
I'm quite certain Felix Salmon understands everything you mentioned, but apparently since he didn't dress the issue in the way you simplify it, it means he doesn't understand the situation. Maybe do a search on his blog for ratings and try glancing through some of the (hundreds) of posts he's written in the past few years before making your judgment?
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].
Maybe I misinterpreted the article too, because an "excess of overcaution" sounds a lot like blame shifting to me, in this case from the rating agencies onto the investors who believed the ratings. The argument implies that because investors were "overcautious", and only willing to buy AAA rated securities, the rating agencies were therefore compelled to rate things AAA they otherwise would/should not have. At any rate, it seems that rating agencies should be rating things accurately regardless of how cautious investors are.
Looking at the line graph, the % of total securities issues rated AAA, it's apparent that between 1991 and 1994 the proportion jumps up from ~20% to ~50% and then floats in a bracket between 50 and 60% for most of the next 2 decades. This obviously happened ahead of the dot com boom, and while I think you make many valid points, none of them address this startling change in the distribution of ratings.
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.
Prior to the 90's there were a number of AAA-rated bank holding companies in Japan, France, Germany, etc, who participated in securitizations by issuing Letters of Credit, lending those bonds their AAA ratings. The downgrades of those led to alternative structures, e.g. reserve funds built up from the collateral pools streams of principal and interest, to garantee timely payment of the bonds' P&I obligations.
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.
> downgrades of those led to alternative structures
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].
Yes, there were several factors that spiraled up together: the entry of 2 new rating agencies, the new credit enhancement structures, the new types of collateral that the agencies deemed to have "predictable enough" P+I cashflows, and the pension funds and insurance companies' appetites for AAA.
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.
No - AAA was always meant to be the best of the best.
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...
Companies cannot be rated higher than the country they are in?
I don't understand why that would make sense, especially in a case like the US - congress being unable to extend the debt ceiling shouldn't have that significant of an impact on Microsoft, a globally diversified company, being able to pay back it's debts...but then, the financial world is full of fun, arbitrary rules.
Microsoft's debt would be issued in dollars.
If the US fails to back the dollar, Microsoft's debt is also worthless, because it's also dollars.
So it would make no sense for MS bonds to be rated higher than the US.
Wow I never looked at it like that before. Of course if the currency collapses the companies operating in it are f'd. We need to resolve the housing foreclosure mess and stop accruing debt.
There are a lot of messes that need to be resolved, but notice that mortgages barely figure in the chart, the housing foreclosure mess is 'merely' shit rolling downhill in this picture
I don't understand the jump in logic you are making from "the US government is at risk of defaulting on it's debt" to "the US dollar is at risk of failing as a currency". Can you explain this?
You seem to be jumping from one conclusion to another which much reasoning to link them, and then drawing another conclusion from that.
I'm afraid there is no jump. If the US defaults interest rates will rise but they can't as the market is dependant on cheap money. That why interest rates have been at 0% for a long as long as I can remember and it is also why QE1 and QE2 were done. To increase the supply of cheap money. If the US defaults the dollar will crash. Look at what happened to Argentina in the late 90s. No I don't think the chances are very significant now but the conditions are certainly there for it to happen. I'm sure a whole paper could be written on this but I am only trying explain where I am coming from.
FYI: using long quotes tends to break page formating on HN. If you not directly quoting something it's best not indent things or to manually break up the lines.
jellicle is correct the ratings are complete bs. If AAA actually meant something the US would have been downgraded years ago. AAA means there is no chance of default no whatever so ever. It should only be reserved for countries with little or ideally no debt. The fact that our politicians and media are openly talking about default means that AAA does apply to the US but it does. So it means nothing.
The (non-BS) default risk of the US is very close to nil. Hence the AAA is deserved. But the currency risk and the interest rate risk is very high. Here's the pair trade if you want it:
Well there are 7 levels of A rating. The US certainly doesn't deserve to the top most tier since there is active discussion of default. No I don't think it actually would but what is the point of these ratings if they are being used like this?
OK, let's look at structural deficit, GDP growth, and Net International Investment Position.
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).
He's saying that it's not the people who are receiving the investments who are driving up demand for AAA ratings, but the investors. People with lots of money aren't willing to take any risks, so they increase demand for AAA-rated investment opportunities. They will patronize ratings agencies that give them more AAA-rated options to invest in.
Only no one needs to be bribed. That's attributing malice where stupidity suffices. The 'shit' is so complicated the rating agencies actually think they are AAA and issue that rating without a bribe. The politicians have plenty of other reasons besides bribes to turn private debts into public debts.
He said everything you said already, in the single phrase "regulatory arbitrage". He's covered debt for years, before he branched out into more broad finance coverage.
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:
And the far right side of the chart is just a continuance of the same thing: our shit fell apart, what should we do? Well, the easiest thing is to bribe the politicians to take our private debts and turn them into public debts. And so it happened. That big tall lavender bar in 2009 is the dark purple lines from a few years prior....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.