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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

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
  No - the ABS markets are all about slicing up pools of debt. Suppose I created a security that would give me back all the loose change found on the streets of Manhattan at any one instant. How much is that worth - $5, $20, more? (there's a lot of streets, and I'm always surprised how often I find a coin). But I can guarantee that it's worth at least $1.00. That would be a AAA risk. And Moody's would rate it so, just by looking at the statistical properties of coins * streets. This adds 1 security to the totals. The 'new idea' is that investors were willing to invest in new 'slices' of existing pools - chosen so that they'd get a AAA rating. The idea itself isn't bogus. But the historical statistics of the subprime market were not valid for the wave of 'new money' moving into the Florida & Vegas markets... Subprime mortgages were a different animal than the rating agencies modeled, and no-one had any incentive to call them out on it.
ChuckMcM 15y ago
A fair point. There is a population of bond investments, the risk to the principle in those investments is scored by a rating agency on a scale from D to AAA [1]. The market prices bonds using a combination of risk (as reported by a rating agency) and desired return. (Return is the independent variable). Economic theory says that the quantity of a good demanded influences the quantity supplied such that prices rise until there are no more buyers who will pay more and no more sellers who will offer for less. This relationship between risk and return manifests itself as a spectrum of bond offerings from those with low risk (AAA) and low return (< 2%) to those with high risk (D, aka 'junk bonds') and a high return (> 9%). [2] It was with this understanding that I used the term 'mathematically impossible' when I was thinking 'the chances that there more AAA bonds in the population of all bond offerings than all the sub-AAA rated bonds put together, is astronomically slim.' For example, California's general obligation bonds are only rated at "A+" (up from BBB but still far from AAA). [3] It could be legitimate, but were that the case the return on non-AAA bonds would be news because that would be the only way people would buy them. Since I'm not seeing offers for C and D grade bonds with 25 and 30% rates of return (and for some reason those folks seek me out and cold call me) I believe the simpler explanation which is that some portion of the bonds that are rated AAA don't deserve that rating (i.e. they are riskier than they purport to be). And that, combined with some of the structural ways in which capital is managed in the world, makes for a much more explosive combination than we might otherwise be expecting. [1] http://www.investopedia.com/articles/03/102203.asp#axzz1SD85zcyb http://www.investopedia.com/articles/03/102203.asp#axzz1SD85... [2] "Investors have been snapping up the new non-investment-grade bonds, having grown frustrated with stocks and with the meager yields on safer government and high-grade corporate bonds." http://online.wsj.com/article/SB10001424052748703960004575427690901781072.html?mod=WSJ_hpp_LEFTWhatsNewsCollection http://online.wsj.com/article/SB1000142405274870396000457542... [3] http://www.treasurer.ca.gov/ratings/history.asp http://www.treasurer.ca.gov/ratings/history.asp
- mdda 15y ago
  But the point of these AAA ratings is that they are the 'top slice' of a pool of lower rated debt. Suppose a typical student is has around $50 in their wallet at any one time : Demanding $50 from a student is pretty risky, and so is demanding $25. But if I have a large enough room full of students (say 100), demanding $2500 from the room (which on average holds $5000) is much less risky than requiring $25 from each person. That's how AAA securities can be built from bad credits : Not everyone goes bad at the same time. So the argument should not be about how crazy the idea of bad credits allowing the creation of good credits. The argument is about correlation coefficients. Moodys / S&P / Fitch got the correlation coefficients between subprime borrowers completely wrong, because they believed that house prices could not all simultaneously decline in the US. And the investment banks had no incentive to explain the errors of their ways to them - and people who weren't "On-Side" at the rating agencies were relegated to lower-growth areas. And the regulators had no clue. And here we are.

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
No - the ABS markets are all about slicing up pools of debt. Suppose I created a security that would give me back all the loose change found on the streets of Manhattan at any one instant. How much is that worth - $5, $20, more? (there's a lot of streets, and I'm always surprised how often I find a coin). But I can guarantee that it's worth at least $1.00. That would be a AAA risk. And Moody's would rate it so, just by looking at the statistical properties of coins * streets. This adds 1 security to the totals. The 'new idea' is that investors were willing to invest in new 'slices' of existing pools - chosen so that they'd get a AAA rating. The idea itself isn't bogus. But the historical statistics of the subprime market were not valid for the wave of 'new money' moving into the Florida & Vegas markets... Subprime mortgages were a different animal than the rating agencies modeled, and no-one had any incentive to call them out on it.

ChuckMcM 15y ago

A fair point. There is a population of bond investments, the risk to the principle in those investments is scored by a rating agency on a scale from D to AAA [1]. The market prices bonds using a combination of risk (as reported by a rating agency) and desired return. (Return is the independent variable). Economic theory says that the quantity of a good demanded influences the quantity supplied such that prices rise until there are no more buyers who will pay more and no more sellers who will offer for less. This relationship between risk and return manifests itself as a spectrum of bond offerings from those with low risk (AAA) and low return (< 2%) to those with high risk (D, aka 'junk bonds') and a high return (> 9%). [2] It was with this understanding that I used the term 'mathematically impossible' when I was thinking 'the chances that there more AAA bonds in the population of all bond offerings than all the sub-AAA rated bonds put together, is astronomically slim.' For example, California's general obligation bonds are only rated at "A+" (up from BBB but still far from AAA). [3] It could be legitimate, but were that the case the return on non-AAA bonds would be news because that would be the only way people would buy them. Since I'm not seeing offers for C and D grade bonds with 25 and 30% rates of return (and for some reason those folks seek me out and cold call me) I believe the simpler explanation which is that some portion of the bonds that are rated AAA don't deserve that rating (i.e. they are riskier than they purport to be). And that, combined with some of the structural ways in which capital is managed in the world, makes for a much more explosive combination than we might otherwise be expecting. [1] http://www.investopedia.com/articles/03/102203.asp#axzz1SD85zcyb http://www.investopedia.com/articles/03/102203.asp#axzz1SD85... [2] "Investors have been snapping up the new non-investment-grade bonds, having grown frustrated with stocks and with the meager yields on safer government and high-grade corporate bonds." http://online.wsj.com/article/SB10001424052748703960004575427690901781072.html?mod=WSJ_hpp_LEFTWhatsNewsCollection http://online.wsj.com/article/SB1000142405274870396000457542... [3] http://www.treasurer.ca.gov/ratings/history.asp http://www.treasurer.ca.gov/ratings/history.asp

mdda 15y ago
But the point of these AAA ratings is that they are the 'top slice' of a pool of lower rated debt. Suppose a typical student is has around $50 in their wallet at any one time : Demanding $50 from a student is pretty risky, and so is demanding $25. But if I have a large enough room full of students (say 100), demanding $2500 from the room (which on average holds $5000) is much less risky than requiring $25 from each person. That's how AAA securities can be built from bad credits : Not everyone goes bad at the same time. So the argument should not be about how crazy the idea of bad credits allowing the creation of good credits. The argument is about correlation coefficients. Moodys / S&P / Fitch got the correlation coefficients between subprime borrowers completely wrong, because they believed that house prices could not all simultaneously decline in the US. And the investment banks had no incentive to explain the errors of their ways to them - and people who weren't "On-Side" at the rating agencies were relegated to lower-growth areas. And the regulators had no clue. And here we are.