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> "Overall, for 2005 to 2007 vintage tranches of mortgage-backed securities originally rated triple-A, despite the mass downgrades, only [...] 4% of subprime se

> "Overall, for 2005 to 2007 vintage tranches of mortgage-backed securities originally rated triple-A, despite the mass downgrades, only [...] 4% of subprime securities had [...] losses imminent or had already been suffered by the end of 2009." > (Also, I think you're missing how huge the decline in home prices was, both as cause and vector of the crisis. A vast amount of paper wealth nominally owned by the middle class vanished in a puff of smoke; most of the crisis was the result of that. But the impacts of an asset price bubble should properly be attributed to its inflation, not it's popping.) Its inflation exists because of how corroded the mortgage ratings were. None of them were correct except relative to each other within the mortgage bond market. You don't rate things AAA when they are really BBB. I understand you might feel that is correct but I sure as hell do not. https://www.moodys.com/sites/products/DefaultResearch/2006600000426807.pdf https://www.moodys.com/sites/products/DefaultResearch/200660... > Aaa 0.00% 0.00% 0.00% 0.00% 0.10% 0.07% That is the expected cumulative default rate for a AAA corporate bond. The mean is .10% with standard deviations of .07%. So when you say "4%" that is absurdly high in comparison yet they were marketed and sold as if they were equivalent risks. https://www.imf.org/external/pubs/ft/fandd/2008/06/pdf/dodd.pdf https://www.imf.org/external/pubs/ft/fandd/2008/06/pdf/dodd.... > The extent and speed of rating downgrades of asset-backed securities. Investors have learned to their cost that the credit ratings of structured credit securities are more likely to suffer rapid and severe downgrades than are corporate bonds (see chart). Not only have downgrades occurred more frequently to subprime securities, they have often been reduced several notches at once because of the sensitivity of such securities’ ratings to increases in assumed credit losses. As a result, investors’ faith in rating agency opinions has been shaken— credit spreads on AAA-rated U.S. residential MBSs have been priced at about the same level as BBB-rated corporate bonds since August 2007. The real value of the AAA-rated residential MBSs were the equivalent of BBB for other securities and had been for years preceding the event. The majority of the market was blinded by the assurances of the credit bureaus which were valuing BBB assets as AAA assets. A credit bureau that doesn't consistently and accurately estimate risk across securities is in many ways worse than useless because it gives a false sense of security where none exists. Similarly, captured referees / regulators / credit bureaus cannot be trusted if you are not the sole organization in control. However, I can see how this is likely more in the realm of opinion so I'll just leave it here but I think the comparison to corporate bonds is relevant.

Lazare 11y ago
I see your point, however... 1) It's worth reiterating that there was a huge housing bubble and a massive devaluation. You say 4% losses is terrible for AAA rated securities (which is true), but you could also say it's pretty amazing for subprime mortgages during a massive housing bubble popping. It's like building a levee that's meant to stand up to all but the most massive floods, and then having a massive flood; the fact that the levee failed it not itself proof that it wasn't engineered correctly. 2) The point I was originally trying to make and got sidetracked from is that if (and seems likely to me) there was an extremely widespread systematic belief that there was no housing bubble and that a coordinated, nationwide drop in housing prices was effectively impossible, then you would see the exact outcomes we saw without the corruption or "corrosion" you posit. In short, you're suggesting that people knew the loans were going to go bad, and put high grades on it knowing there was a real risk of default. I would put it to you that actually no one inside the system believed the loans were going to go bad, and the high grades were put on it in the incorrect belief that there was no real risk of default. There's been a lot of research on this subject, but to me the most compelling is research showing that "insiders" did not diversify away from the crap they were selling. See facts 9 and 10 from this paper[1] for example, which notes that Lehman, for example, was using internal models which estimated the odds of a bursting bubble at 5%, whereas they assigned 30% odds to scenarios that assumed absolutely impossible and historically unprecedented house price growth. Bear Stearns executives invested heavily in their own bank's funds which in turn were invested in MBS. Similarly, many loan originators got into trouble not because they bundled the loans up and sold them on (as their risk models required them to do), but because they kept too many of them, thinking they were great investments. If Lehman and Bear Stearns and Bank of America were the suckers, who was doing the exploiting? (And the biggest winners were people like John Paulson, who had no clue how the mortgage market worked, and had never traded mortgages before.) From where I stand, there is a compelling, coherent story of people being idiots, but the cynical, blatant corruption seems missing. If your model says there's a 5% chance of housing prices dropping, then your model is wrong, but your conclusion about the risk of impairment of AAA tranches makes a lot of sense. So the next question is, well, did you really believe that there was a 5% chance of housing prices dropping? And the people involved bet their careers and personal fortunes on that, so...apparently they did? Edit: I highly recommend the entire paper, and in particular you may find "fact 12" of interest, as it gets into the weeds on how the ratings were actually calculated, why the ratings on MBSs ended up being mostly accurate, why the ratings on CDOs ended up being completely wrong, and why there was a difference. [1]: https://www.bostonfed.org/economic/ppdp/2012/ppdp1202.pdf https://www.bostonfed.org/economic/ppdp/2012/ppdp1202.pdf

Lazare 11y ago

I see your point, however... 1) It's worth reiterating that there was a huge housing bubble and a massive devaluation. You say 4% losses is terrible for AAA rated securities (which is true), but you could also say it's pretty amazing for subprime mortgages during a massive housing bubble popping. It's like building a levee that's meant to stand up to all but the most massive floods, and then having a massive flood; the fact that the levee failed it not itself proof that it wasn't engineered correctly. 2) The point I was originally trying to make and got sidetracked from is that if (and seems likely to me) there was an extremely widespread systematic belief that there was no housing bubble and that a coordinated, nationwide drop in housing prices was effectively impossible, then you would see the exact outcomes we saw without the corruption or "corrosion" you posit. In short, you're suggesting that people knew the loans were going to go bad, and put high grades on it knowing there was a real risk of default. I would put it to you that actually no one inside the system believed the loans were going to go bad, and the high grades were put on it in the incorrect belief that there was no real risk of default. There's been a lot of research on this subject, but to me the most compelling is research showing that "insiders" did not diversify away from the crap they were selling. See facts 9 and 10 from this paper[1] for example, which notes that Lehman, for example, was using internal models which estimated the odds of a bursting bubble at 5%, whereas they assigned 30% odds to scenarios that assumed absolutely impossible and historically unprecedented house price growth. Bear Stearns executives invested heavily in their own bank's funds which in turn were invested in MBS. Similarly, many loan originators got into trouble not because they bundled the loans up and sold them on (as their risk models required them to do), but because they kept too many of them, thinking they were great investments. If Lehman and Bear Stearns and Bank of America were the suckers, who was doing the exploiting? (And the biggest winners were people like John Paulson, who had no clue how the mortgage market worked, and had never traded mortgages before.) From where I stand, there is a compelling, coherent story of people being idiots, but the cynical, blatant corruption seems missing. If your model says there's a 5% chance of housing prices dropping, then your model is wrong, but your conclusion about the risk of impairment of AAA tranches makes a lot of sense. So the next question is, well, did you really believe that there was a 5% chance of housing prices dropping? And the people involved bet their careers and personal fortunes on that, so...apparently they did? Edit: I highly recommend the entire paper, and in particular you may find "fact 12" of interest, as it gets into the weeds on how the ratings were actually calculated, why the ratings on MBSs ended up being mostly accurate, why the ratings on CDOs ended up being completely wrong, and why there was a difference. [1]: https://www.bostonfed.org/economic/ppdp/2012/ppdp1202.pdf https://www.bostonfed.org/economic/ppdp/2012/ppdp1202.pdf