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

http://www.nytimes.com/2010/04/26/opinion/26krugman.html

by mcantelon • 16 years ago

149 70 16 years ago

nytimes.com

Alex3917• 16 years ago

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

akronim• 16 years ago

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

goatforce5• 16 years ago

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...

jsm386• 16 years ago

Especially ironic/inaccurate given the full context of the quote: And no, that’s not hyperbole: of AAA-rated subprime-mortgage-backed securities issued in 2006, 93 percent - 93 percent! - have now been downgraded to junk status.

sgoraya• 16 years ago

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.

eavc• 16 years ago

If anyone is interested in a very clear example of the story behind the stat, I highly recommend this podcast/radio episode: http://www.thisamericanlife.org/radio-archives/episode/405/i...

matasar2• 16 years ago

It seems to me that rating agencies should be paid by the institutional investors that buy the bonds, not the banks trying to sell them. That might help the incentives line up better.

Am I crazy? Nobody suggests this, and I think I'm missing something crucial here.

btilly6• 16 years ago

The problem is that the institutional investors buying the bonds are much smaller, and there is no way to keep the information from leaking. Therefore most of those investors won't be willing to pay for the bonds, and the ones that can pay will be paying less money.

That doesn't mean that this model is not viable. But it isn't viable at the kind of margins that the rating agencies would like to remain accustomed to.

matasar2• 16 years ago

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.

jey2• 16 years ago

Rating agencies seem like an absurd idea altogether. Have they never heard of the perils of having a single point of failure? Much less a single point of failure that's a government-created oligopoly? Yikes.

It seems that businesses are just running on an outdated model developed when information sharing was a lot harder, so only condensed forms like quarterly reports and press releases were feasible. But now that information sharing is a lot easier, shareholders should be demanding more openness from businesses -- yes, today a lot of that information is considered to be a trade secret, but at the same time shareholders need to stop allowing businesses to get away with what's equivalent to deceit through "creative" accounting (e.g. apportioning profits/debts amongst subsidiaries). That's just a textbook example of exploiting information asymmetry. Shareholders should expect more information about the business' books and transactions. There must be some natural equilibrium between being open about transactions and protecting strategic advantages, but right now we have the functional equivalent to price fixing, er, information fixing -- companies don't release relevant information because "no other company does" and shareholders don't expect real operating information either because that's not part of the status quo.

Wouldn't an investment bank that was so confident in the principles behind its analysis that it was willing to list all its transactions in a continuously-updated XML file, despite the risk of copy-cats, seem like a pretty damn good investment? They wouldn't have to divulge their proprietary methods of analysis, just make their holdings public. This would greatly improve the efficiency of markets as investors could use their own proprietary methods to estimate the risk of an entity's portfolio management strategy when deciding whether to invest in it.

And there's definitely historical precedent for this -- the fabled value investor Benjamin Graham didn't go to great lengths to hide his trades, instead he'd use them as examples in his classes, and yeah, people copied him. And he still made boatloads of money.

gaius2• 16 years ago

Well, it's more subtle than that. The big ratings agencies are Fitch, S&P and Moody's. They are competitors for the business of issuers. So each one is incentivized to rate higher than the others, without blatantly being seen to take the piss.

The problem with complete openness is that it encourages short-termism. You see this even with quarterly results, companies that have recently gone public (and thus have minimal reputation) manage from quarter to quarter to quarter and are hugely volatile. Imagine working for a manager who only cares about the share price tomorrow.

The risk of your XML file is not copycats, it's front-running.

cma• 16 years ago

http://www.cepr.net/index.php/beat-the-press/krugman-nails-t...

Dean Baker has been suggesting that either the exchange or the SEC take over selection of the rating agency for over a year now.

btilly6• 16 years ago

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 perfect world we'd be forcing the banks right now to write down securities that took a hit, forcing them to declare losses, which would mean that they wouldn't be paying out absurd bonuses. This would absorb the money we gave them from the bailout. In a slightly less perfect world we'd be enacting useful regulations that would avoid this problem returning for a few decades (such as happened during the Great Depression).

In the real world we gave the banks a big bailout, have let them mark securities to models of their choice, and they paid themselves big bonuses on their "profits". Of course they are still sitting on lots of toxic securities (like bad CMBS and the junk bonds issued by private equity) that they have not marked down yet. When that blows up we have good odds that they'll ask for another bailout. And the behavior of both parties says that the leadership will try to get it for them. They nearly didn't manage to deliver it last time, and given the public outrage since, they may not be able to deliver it next time.

This could lead to interesting times. Interesting times.

gaius2• 16 years ago

which would mean that they wouldn't be paying out absurd bonuses

No it wouldn't. Investment banks are huge and diverse businesses. If you're an FX trader, nothing whatsoever to do with mortgage-backed securities, and you've done your job well this year and made excellent profits (which for the bank as a whole offset their losses) then why shouldn't you get a bonus as usual?

Of course the loss-making traders shouldn't get bonuses (that is after all the point of the bonus system) but lumping everyone in with them is both inaccurate and counter-productive.

joe_bleau• 16 years ago

I've wondered this too. As an employee of a small company, I really wish I could use the same argument (and trust me, I've tried). "Hey boss, I'm doing the work of two people, at about a 40% discount to market rates for the average embedded engineer. You don't seem to think I'm average, and there's no question that you're more than happy with my performance. I realize business is off right now and sales suck, but why shouldn't I get a bonus/raise?" "Cause we don't have any more money, and the government won't give us any."

I really like my job, but sometimes it's tough not to be jealous of the world of big money and government.

I guess my answer to your question might be: "because Joe two floors down blew up, and we wouldn't exist as a company anymore if not for the government bailouts".

anigbrowl4• 16 years ago

I'm sure the head chef on the Titanic wasn't too happy when it started sinking either.

Big powerful organizations attract skilled employees by offering status, pay and economic security. And at the individual level, diligent and honest performance should indeed be rewarded. But the whole reason most of us obey the law and pay our taxes is founded on the idea of mutuality: our interdependence is essential to freedom economic success.

Commercial losses are ultimately a shareholders' problem. But when the public become shareholders or creditors by necessity, it's facile to say that individually successful employees are economic free agents who should earn the full reward of their productivity. Nothing prevents them from leaving to join a more stable competitor, or establishing their own funds: if they choose to stay with an organization that benefits from public expenditure, they've made a choice of financial security over financial liberty.

Besides, limiting the bonus payments of the productive employees when other staff rack up huge losses is a fabulous economic incentive to improve risk management and governance within the organization. Those who consider such matters above their pay grade or outside their job description are obviously not ready to leave the kiddie pool.

RyanMcGreal• 16 years ago

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

btilly6• 16 years ago

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.

anamax• 16 years ago

And unicorns are magic horses.

The properties of ideal entities aren't much use in a universe where nothing approximating such entities actually exists.

Note that Fannie and Freddie actually lied about the mortgages pools that they constructed (said mortgages contained more subprime than they admitted). This not only defrauded the folks who bought those pools, it also made the entire mortgage market look safer than it actually was.

Note that it was regulators who pushed subprime mortgages and insurance for such securities (so they could justify "encouraging" banks to hold them as regulated assets). Said regulators also gave ratings monopoly AND told banks that they had to hold Fannie and Freddie stock, which put many of them into technical default when Fannie and Freddie went down.

At best, regulation is systemic risk. Often, it's corruption backed by a threat of violence.

Symmetry• 16 years ago

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.

barry-cotter• 16 years ago

Lucas Critique

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

david927• 16 years ago

93% isn't bad luck. 93% is fraud.

_delirium2• 16 years ago

Not that I think everything was above-board, but to be fair, these are hugely correlated instruments: it's not reporting 93% of all AAA debt tanked, but 93% of all AAA-rated derivatives of subprime mortgages. Given the subprime-mortgage crash, it's not surprising that everything tied to subprime mortgages uniformly tanked too.

The way an AAA-rated derivative of a subprime mortgage could exist to begin with was via "tranching", where debt was sliced up into different buckets of repayment priority, which heightened the correlation. In a minor crash, the AAA securities would do okay, because they'd get the payments from the non-defaulting loans, and the lower-rated tranches would take the losses. But once you go over the threshhold where there isn't enough money to even repay the top tranches, then everything tanks all together. So really, near-0% and near-100% default rates were the likely outcomes.

WorkerBee• 16 years ago

but to be fair, these are hugely correlated instruments

That makes them more risky, not so? How did they get the AAA rating then?

akadien• 16 years ago

It's more likely underpaid raters at Moody's and S&P being intimidated by overpaid traders at Goldman Sachs and Deutsche Bank. I'm reading "The Big Short" (highly recommended), and it puts all of this and the current GS hearings in the right perspective.

yummyfajitas5• 16 years ago

Quant's at rating agencies get the same pay as any back office quant.

asymmetric• 16 years ago

what does this have to do with news.yc ? it's not even about startups!

JCThoughtscream• 16 years ago

From the FAQ:

"On-Topic: Anything that good hackers would find interesting. That includes more than hacking and startups. If you had to reduce it to a sentence, the answer might be: anything that gratifies one's intellectual curiosity.

Off-Topic: Most stories about politics, or crime, or sports, unless they're evidence of some interesting new phenomenon. Videos of pratfalls or disasters, or cute animal pictures. If they'd cover it on TV news, it's probably off-topic."

This one's a bit of a gray area, as it's heavily political in nature, but the mechanics of loan securities is of both intellectual and personal interest to what I'd imagine is a heck of a lot of HN readers.

aac743• 16 years ago

Krugman fails to mention that this is the corrupt fallout from his cheerleading in 2002 for low interest rates in order to create a housing bubble to fill the void of the .com bubble !

"Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble." - Krugman 2002

http://www.nytimes.com/2002/08/02/opinion/dubya-s-double-dip...

DuncanIdaho2• 16 years ago

Now I don't understand what your motive is - but your quote is taken waaay out of context...

Original quote: "The basic point is that the recession of 2001 wasn't a typical postwar slump, brought on when an inflation-fighting Fed raises interest rates and easily ended by a snapback in housing and consumer spending when the Fed brings rates back down again. This was a prewar-style recession, a morning after brought on by irrational exuberance. To fight this recession the Fed needs more than a snapback; it needs soaring household spending to offset moribund business investment. And to do that, as Paul McCulley of Pimco put it, Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble."

Here Krugman basically quotes another source. The way I interpret this quote (and article) is not cheerleading for lower interest rates. The message to me is that whole system is unsustainable and that only move that will be able to perpetuate the lie is to replace one bubble with the next.

In this context Krugman's vision has proven prophetic.

The whole notion, nothing personal - I have noticed it more than once, that Krugman somehow argued that replacing one bubble with another is good for economy somehow is ridiculous.

aac743• 16 years ago

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 by soaking up the price rises due to commodity speculation.

He also does not mention the FED money printing in the 30s to artificially support the pound and stop the draw on gold from London. Could this have had something to do with the boom then ???

The moral of the story is don't let the government and central bank 'run' your economy. All they can do is make bad guesses and try and cover up reality.

Panama has done without a central bank for a hundred years and look at the state it is in: http://www.costaricapages.com/panama/blog/wp-content/uploads... Who 'runs' their economy ??? Who prints their money ???

yummyfajitas5• 16 years ago

The point of that editorial is that business investment won't end the recession, so the only hope is housing.

"To fight this recession the Fed needs more than a snapback; it needs soaring household spending to offset moribund business investment. "

Krugman is just repeating the same "insufficient demand" theory of recessions that Keynesian economists are using today.

c00p3r• 16 years ago

This rating agencies are making their money the same way the big business consultants does - by confirming client's illusions and narcissistic views. This is called corruption.

bkmrkr• 16 years ago

Your title is wrong and misleading

fname• 16 years ago

If anyone listened to the hearings, they quoted a part from the book, "The Big Short: Inside the Doomsday Machine" which discusses some of what the author thinks were the inner workings. I've been reading through it now and cannot recommend it enough.

http://www.amazon.com/Big-Short-Inside-Doomsday-Machine/dp/0...

nickpinkston• 16 years ago

Can someone actually find the source for this 93% figure? I haven't been able to. I just keep seeing the link back to the NYT page. I'd be good to actually see real numbers - not just Krugman's opinion.

ksraines5• 16 years ago

Let's not forget that Krugman was one of the chief advocates of the housing bubble (before it popped) and that his "berating of the raters" should begin with an apology.

http://blog.mises.org/10153/krugman-did-cause-the-housing-bu...

tansey• 16 years ago

That is bunk. That blog article is pulling a few quotes from 2001. In 2001 we had a recession with high unemployment, and lowering interest rates was sound advice.

If you find some quotes from 2004 or beyond where Krugman actually advocates policies that would encourage a housing bubble, then you may have a case.

ksraines5• 16 years ago

Please see my comment above. You are evidently confused about the history of the housing bubble: it was beginning just as Krugman was making these comments and writing the article I link to below.

The burden is, in fact, on you to find a link from circa 2004-6 by Krugman calling for restraint of the bubble whose inflation he advocated so fiercely. See above for a more detailed exposition of this point.

Anyways, here is another article from 2002. I don't know how you can get any more incriminating:

Quoting Krugman: To fight this recession the Fed needs more than a snapback; it needs soaring household spending to offset moribund business investment. And to do that, as Paul McCulley of Pimco put it, Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble.

http://www.nytimes.com/2002/08/02/opinion/dubya-s-double-dip...

BTW, asking for a quote from 2004 calling for the creation of a housing bubble is a bit ridiculous: by then the housing bubble was in full bloom.

http://upload.wikimedia.org/wikipedia/en/c/c1/Median_and_Ave...

As you can see, late 2002 (when the above article was written) would have been just at the beginning of the disaster.

(sorry for the delayed reply; at work all day.)

spot• 16 years ago

those quotes are all from 2001. that's more than just a little "before it popped". this criticism is worthless.

ksraines5• 16 years ago

No, your criticism is worthless. Insofar as you are correct in pointing out where I am correct, I give you some credit. But you fail to appreciate the full scope of my correctness and thus miss the whole point.

1. Consider: who would actually be so buffoonish as to call for the creation of a financial bubble at the peak moment before said bubble was about to burst - particularly when the bubble had reached an historical scale. Krugman is silly, but not that silly.

2. As it turns out, he was calling for the bubble at that crucial moment in history which we now recognize as the actual creation of the bubble. http://upload.wikimedia.org/wikipedia/en/c/c1/Median_and_Ave...

Let me spell it out for you: he got what he asked for, when he asked for it.

3. Given that he called for the creation of a bubble, I am willing to assume that perhaps he didn't mean for it to get so over-inflated. But that puts the burden on you to find an article circa 2004 for him saying: stop, I meant only inflate it a little ...

Of course he did not call for the creation of the bubble just before it popped. In fact, it is much worse: he called for the inflation of the bubble just as it was getting started.

We all know how that ended ...

anigbrowl4• 16 years ago

I'm not a big fan of Krugman, but let's also not forget that we were in a recession at the time of those remarks; when Krugman was saying the Fed should raise interest rates a few years later, and taht the US was addicted to Chinese treasury purchases, libertarians scoffed and called him an alarmist.

This 2005 example of libertarian economic thought is particularly ironic, arguing that measures of inflation like CPI give too much weight to housing and car prices while an adjacent advert promotes a book explaining how the crisis was caused by too much easy money: http://www.cato.org/pub_display.php?pub_id=3752

Other sparkling jewels of economic wisdom include his prediction at the beginning of 2008 that recession was a non-issue, or his comments from earlier in the decade (when the Fed had raised rates a bit) that the nation would achieve substantial long term benefits from the 'glorious housing boom' created by previously low rates, which had allowed many refinancers to invest and consume more.

Physician, heal thyself.

ksraines5• 16 years ago

Point taken. However, Krugman's comments were a little stronger than what you suggest. He explicitly called for the creation of a housing bubble (see my other response below).

Please don't take the link as a blanket endorsement of libertarianism; it was just the first link that came up as a result of my google search. I remembered reading up on Krugman's predictive failures many months ago ...

Krugman stopped being an economist a long time ago and is now a political hack - regardless of whether or not he has a point in this particular instance. I imagine that you didn't need Krugman to tell you that the raters were issuing ridiculous ratings ...

kevin_morrill• 16 years ago

Thank god that we have government regulated credit ranking agencies to protect us from this mess and having to use our own judgment when investing. Oh wait... hmmm...

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

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