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It isn't clear to me why AAA rated bonds represent such systemic risk, the article says the following: "They breed complacency and regulatory arbitrage, and th

by orofino 15y ago

It isn't clear to me why AAA rated bonds represent such systemic risk, the article says the following: "They breed complacency and regulatory arbitrage, and they are a key ingredient in the cause of all big crises, which is leverage." Is the author arguing that these should all just be rated below AAA and as such be accompanied with higher interest rates? This would obviously depress the rate of issuance because companies would be less inclined to take the terms (at least in theory). This makes sense to me, but doesn't necessarily indicate that AAA rated bonds inherently have systemic risk as the author states. Perhaps I'll read the article a second time through.

tptacek 15y ago
From the article: Then look at the green line. Triple-A debt wasn’t a huge part of the bond market back in the early 90s, but for the past decade it has invariably accounted for somewhere between 50% and 60% of total global fixed income issuance. 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. That seems like the nut. It's prima facie obvious that much of what is called AAA can't be AAA; it almost mathematically beggars the definition of AAA. Meanwhile, all kinds of contracts, regulations, and instruments rely on AAA ratings to prevent money that can't reasonably be put at risk from going into e.g. mortgage bonds.
- orofino 15y ago
  Then I'm inclined to disagree at another portion of the post which seems somewhat contradictory to the point: "it wasn’t an excess of greed and speculation which led to the financial crisis, but rather an excess of overcaution" The greed then exists in alternate areas of the system. It isn't AAA bonds that are the issue, it is the fact that lesser bonds are being rated as AAA. Why are they being rated that way? The ratings companies have conflicts of interest and were... (wait for it) greedy. In addition, calling this an "excess of overcaution" is laughable, if I can get decent returns from a "risk free" investment, that isn't cautious, it is logical.
  - joe_the_user 15y ago
    Hmm, I guess I agree but the thing is that "greed" and "over-caution" actually very similar. Over-caution is greed for income without risk. For example, Bernie Madoff's appeal wasn't based on offering income level that no mutual fund could match but rather offering an apparent combination of income and stability that no mutual fund could match (10%/year as reported each quarter).
    - orofino 15y ago
      I think there are some differences, but regardless within the context of this article the author states: "it wasn’t an excess of greed ..., but rather an excess of overcaution" I disagree with this statement, and clearly, based on your definition here, this can't be true either. Unless, saying "is wasn't greed it was greed" actually makes sense. Obviously I don't think you believe that, I'm just pointing out a major issue with the article as a whole.
  - rgraham 15y ago
    It was pseudo caution. The finance industry saw that investors wanted to (in some cases, had to) buy conservative investments like AAA paper. They sold them a fantasy of conservative investment. It was so compelling that the utterly ridiculous notion of that much AAA paper was ignored. After calling it 'excess of overcaution' he declared that it is leverage that causes crises. Leverage does not connect strongly with caution to me.
- ChuckMcM 15y ago
  This is exactly correct. Basically folks are lying about the AAA rating of this debt, it is not mathematically possible to have 65% of the bonds issued to be risk free. Therefore, there are bonds here which are not AAA, therefore we can expect that they will fail. Now the kicker ... There are funds which can only invest in AAA type securities, think pension funds which have contractual obligations far in the future to provide money. When these AAA instruments blow up, they will take down pension funds which will cash out their equities to rebalance their holdings which will cause a market crash that made 2009 look like a minor correction, which will, in all likelyhood throw us into a deep deep depression because rating agencies will have lost so much credibility that they won't be believed and governments won't have any way to raise funds to 'bail out' their economies. Kind of a scary thing to think about.
  - jamesaguilar 15y ago
    Seen a lot of interesting uses of the term "mathematically" in this thread. Is there some theorem that proves a certain portion of issued debt must be risky? It seems unlikely to me.
    - scythe 15y ago
      >Is there some theorem that proves a certain portion of issued debt must be risky? It seems unlikely to me. No, but there is a theorem -- or call it an axiom -- that the amount of debt issued is equal to the amount of debt owed... okay, not a theorem, it depends on people being honest. Now the thing that's hard to believe is that we went from a situation in which the vast majority of debtors were unreliable to the current situation where a significant proportion are considered reliable, and did all of this without any really significant or obvious cultural change, and during a period in which bankruptcy was just as common as before... basically, the "mathematically impossible" thing is that there is a lot more debt being considered reliable but there aren't any more reliable debtors. Now, you could contest the latter: are there more reliable debtors today? It's not impossible, but I don't see very many, beyond the US Treasury.
      - mdda 15y ago
onemoreact 15y ago
There is several ways systems can break down. One of the largest in recent US history went something like this: You have 100 million. Now you can put it into a bank, but there is no FDIC for banks so AAA security's are basicly the safest place to put that money. You now look for someone selling safe debt and don't really care about intrest rates just AAA. Banker notices this demand and sells AAA debt from a pool of AA grade debt and get's to keep the intrest as long as a rating agency is willing to certify his bonds as AAA. But how do you satisfy the new demand for AA debt, well a slightly larger pool of A debt can quickly become AA debt etc. But wait if I can take A to AA then AA to AAA why not save some paper work and make AAA from A. After a while demand for AAA debt is satisfied with large amounts of what amounted to junk bonds and rediculus amounts of leverage. And that huge flow of money went directly to people and institutions that spent it, which stimulated the economy and make it like this where far more stable than they actually where. Meanwhile the people that bought the bonds in the first place now have even more money because the economy is doing great!!!, or atleast it looks that way.
encoderer 15y ago
The real fiscal danger -- in addition to the murky issue of complacency -- is that financial institutions can call AAA debts "risk free" and hold them off their balance sheet. It allows them to leverage-up far more than they otherwise could, and since the big investment banks are publicly traded now it exposes shareholders to undisclosed risk. This is tightly correlated with the problem of credit default swaps. At their core, a CDS is an insurance policy. You pay me a premium every year. If the insured bond defaults, I'll pay you out. Well, if I'm insuring a AAA bond, or the AAA tranche of a bond, I can call that risk-free insurance. IOW, I can call the premiums I'm earning to be risk-free profit.

by orofino 15y ago

tptacek 15y ago

From the article: Then look at the green line. Triple-A debt wasn’t a huge part of the bond market back in the early 90s, but for the past decade it has invariably accounted for somewhere between 50% and 60% of total global fixed income issuance. 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. That seems like the nut. It's prima facie obvious that much of what is called AAA can't be AAA; it almost mathematically beggars the definition of AAA. Meanwhile, all kinds of contracts, regulations, and instruments rely on AAA ratings to prevent money that can't reasonably be put at risk from going into e.g. mortgage bonds.

orofino 15y ago
Then I'm inclined to disagree at another portion of the post which seems somewhat contradictory to the point: "it wasn’t an excess of greed and speculation which led to the financial crisis, but rather an excess of overcaution" The greed then exists in alternate areas of the system. It isn't AAA bonds that are the issue, it is the fact that lesser bonds are being rated as AAA. Why are they being rated that way? The ratings companies have conflicts of interest and were... (wait for it) greedy. In addition, calling this an "excess of overcaution" is laughable, if I can get decent returns from a "risk free" investment, that isn't cautious, it is logical.
- joe_the_user 15y ago
  Hmm, I guess I agree but the thing is that "greed" and "over-caution" actually very similar. Over-caution is greed for income without risk. For example, Bernie Madoff's appeal wasn't based on offering income level that no mutual fund could match but rather offering an apparent combination of income and stability that no mutual fund could match (10%/year as reported each quarter).
  - orofino 15y ago
    I think there are some differences, but regardless within the context of this article the author states: "it wasn’t an excess of greed ..., but rather an excess of overcaution" I disagree with this statement, and clearly, based on your definition here, this can't be true either. Unless, saying "is wasn't greed it was greed" actually makes sense. Obviously I don't think you believe that, I'm just pointing out a major issue with the article as a whole.
- rgraham 15y ago
  It was pseudo caution. The finance industry saw that investors wanted to (in some cases, had to) buy conservative investments like AAA paper. They sold them a fantasy of conservative investment. It was so compelling that the utterly ridiculous notion of that much AAA paper was ignored. After calling it 'excess of overcaution' he declared that it is leverage that causes crises. Leverage does not connect strongly with caution to me.
ChuckMcM 15y ago
This is exactly correct. Basically folks are lying about the AAA rating of this debt, it is not mathematically possible to have 65% of the bonds issued to be risk free. Therefore, there are bonds here which are not AAA, therefore we can expect that they will fail. Now the kicker ... There are funds which can only invest in AAA type securities, think pension funds which have contractual obligations far in the future to provide money. When these AAA instruments blow up, they will take down pension funds which will cash out their equities to rebalance their holdings which will cause a market crash that made 2009 look like a minor correction, which will, in all likelyhood throw us into a deep deep depression because rating agencies will have lost so much credibility that they won't be believed and governments won't have any way to raise funds to 'bail out' their economies. Kind of a scary thing to think about.
- jamesaguilar 15y ago
  Seen a lot of interesting uses of the term "mathematically" in this thread. Is there some theorem that proves a certain portion of issued debt must be risky? It seems unlikely to me.
  - scythe 15y ago
    >Is there some theorem that proves a certain portion of issued debt must be risky? It seems unlikely to me. No, but there is a theorem -- or call it an axiom -- that the amount of debt issued is equal to the amount of debt owed... okay, not a theorem, it depends on people being honest. Now the thing that's hard to believe is that we went from a situation in which the vast majority of debtors were unreliable to the current situation where a significant proportion are considered reliable, and did all of this without any really significant or obvious cultural change, and during a period in which bankruptcy was just as common as before... basically, the "mathematically impossible" thing is that there is a lot more debt being considered reliable but there aren't any more reliable debtors. Now, you could contest the latter: are there more reliable debtors today? It's not impossible, but I don't see very many, beyond the US Treasury.
    - mdda 15y ago

onemoreact 15y ago

There is several ways systems can break down. One of the largest in recent US history went something like this: You have 100 million. Now you can put it into a bank, but there is no FDIC for banks so AAA security's are basicly the safest place to put that money. You now look for someone selling safe debt and don't really care about intrest rates just AAA. Banker notices this demand and sells AAA debt from a pool of AA grade debt and get's to keep the intrest as long as a rating agency is willing to certify his bonds as AAA. But how do you satisfy the new demand for AA debt, well a slightly larger pool of A debt can quickly become AA debt etc. But wait if I can take A to AA then AA to AAA why not save some paper work and make AAA from A. After a while demand for AAA debt is satisfied with large amounts of what amounted to junk bonds and rediculus amounts of leverage. And that huge flow of money went directly to people and institutions that spent it, which stimulated the economy and make it like this where far more stable than they actually where. Meanwhile the people that bought the bonds in the first place now have even more money because the economy is doing great!!!, or atleast it looks that way.

encoderer 15y ago

The real fiscal danger -- in addition to the murky issue of complacency -- is that financial institutions can call AAA debts "risk free" and hold them off their balance sheet. It allows them to leverage-up far more than they otherwise could, and since the big investment banks are publicly traded now it exposes shareholders to undisclosed risk. This is tightly correlated with the problem of credit default swaps. At their core, a CDS is an insurance policy. You pay me a premium every year. If the insured bond defaults, I'll pay you out. Well, if I'm insuring a AAA bond, or the AAA tranche of a bond, I can call that risk-free insurance. IOW, I can call the premiums I'm earning to be risk-free profit.