Dealbreaker

Is this new information?

So basically your defense of rating agencies is that nobody really thought they were competent in the first place? How does the fact that we suspected they were wrong make them any less of a punching bag for being wrong?

everything is just a rehash. but its the way its told that counts. the above piece is better than say...a bloomberg attempt...just. but keep on trying, it shows some promise.

This sounds like a serious cognitive dissonance issue on the part of investors who have for years a. made sport of the fact that the agencies are almost always behind the curve and b. are well aware there is no such thing as a free lunch on wall street.

The culpability in this regard I think lays at the feet of the dealers, who are actually marketing these things as a free lunch i.e. explaining away the cost differential (anyone who has heard the pitch knows what I am talking about) and of course the dimwits who believed the pitch. The rating agencies will take their lumps right or wrong for actually being wrong, but from what I understand of the process and the people involved they really did think they were doing their best, until I see any evidence otherwise.

The ratings agencies knew, the banks knew, the mortgage originators knew, the mortgage brokers knew, the investors were greedy and the home owners lived in hope. It was all greed and stupidity. But I did not have a clue. All I know is my house is worth a lot more than I would get for it. And you should see the high prices they paid for crap in Ireland, Spain, England and Las Vegas.

It's almost like there's some kind of relationship between risk and return.....

next up, PE.

"All I know is my house is worth a lot more than I would get for it. "

Actually your house is worth what you can get for it.

I can say the car I drove in high school was worth $2 million, even though people wouldn't give me $200 for it. That doesn't make it true.

Interesting concept, Anonymous 10:00. Tell me more.

I think the important question here is why did the market seem to fail so massively? Why so much stupidity? Could it be the mortgage crisis was just one manifestation of an economy driven by artificially low interest rates???

And who was responsible for that?

TANSTAAFL

http://law.wustl.edu/WULQ/77-3/773-619.pdf

Is there fault to be layed at the feet of the ratings agencies? Yes. I conceded that yesterday. But I want to revisit a line I "threw away", but probably should have made clearer:

Anyone who reads this site knows i am a pretty strong "libertarian" (I use quotes because liberatarian has a sh-t ton of connotations and some of the self-professed libertarians are anarchists in disguise or just crazy...im mainstream libertarian). That said, it is pretty obvious that i have a pretty strong disdain for government intervention in most instances. I believe a large part of this mess was created BY the government--and any attempts to "fix" this with new regulations will only push problems down the line.

If anyone recalls, Mikey Milken went off and sold junk bonds to the S&Ls under the guise of "if you diversify enough then you are getting a free lunch in junk rated paper" back in the 80s and 90s (hmm, sound familiar??). When they caved (sound familiar) and the S&Ls had to firesale them and be bailed out (sound familiar??) the government declared they could only buy "investment grade" paper and ordained the ratings agencies as ultimate arbiters of that investment/junk status. Since, if a bond is rated junk, there is an automatic reduction in willing (able) buyers. To circumvent Milken's method of selling individual junk bonds, then declaring that through diversification they are stable as a portfolio the ibks simply bundled them at the start. Why? Because then they could get investment grade status, and then institutions could purchase them (in a low yield environment).

Now let's take the contra-example. What if institutions weren't required to hold only investment grade paper? Well, then these CDOs would probably have been given more accurate (lower) ratings. It is the same crowding out effect as when you add a substantial amount of subsidised housing: all the housing around the area's price increases because of decreased supply. You are either subsidised (and thus cheap) or you arent (and thus expensive). With securities you are either investment (expensive) or junk (cheap). By negating a stratification of ratings the agencies were incented to rate things as either AAA or junk. You get a barbell, not a pyramid. This effect is only amplified by the basel accords and other regulations stating that reserve capital must be seen in terms of risk. As Carney said (and im simplifying) AAA securities didnt count as liabilities on European balance sheets, since they were seen as risk free.

This is not to say the gov't intervention is ALWAYS bad, but in the rush to seem like they're doing SOEMTHING regulators forget about secondary incentive cascades (see Carney's post on behavioral finance and regulation). Case in point: Dodd's new, rediculous mortgage market "fixer".

It is also important to remember that these subprime ARM borrows are not being forced out of THEIR homes. They are being forced out of the BANK'S (lender/servicer/etc) homes. If they put no money down, and payed, say 1/30 (1 year out of 30) they maybe "own" their bathroom...but that's it.

@Anonymous 10:07AM.......There are many knowledgeable market savvy enters on this site that deal with serious monetary business. Some of us do not like ripping up people just for laughs and making idiotic statements. The more I read you entrys on the site the more I think of you are a qualified airhead. Now, stop the bullshit and make some sense.

maybe it faied so massively is because at the end of the day it is a (ytm) yield -to-me mentality. all i got to do is get through year end for my bonus and if it blows up it is opm anyway

A) Sorry for how long that was.

B) @10:22 holler at the Wash U love.

@1-2 agree that the evil interventionist government created externalities resulting in the need to create AAA securities out of shit, still disagree with your presumption that Moodys et al. intentionally mis-rated the products as opposed to just screwed up the analysis, structuring group didn't actually understand the underlying collateral, not enough contact with the residential group, flawed assumptions etc. But maybe time will prove me wrong on this and there really was a conspiracy element as you suggest.

s75: you should go suck 1-2's cock

Were the agaencies incompetent when they had most Japanese banks rated AAA?
Or JP Morgan? Or Bethlehem Steel? Or do market just move and change, making fools of *everyone* given time? Were the agencies dishonest when they had Orange County as high investment-grade?

I mean, this has NEVER happened with CDOs before. Right? AAA-CDOs never hit a rough patch, I bet...

Aug. 26, 2003
Fitch Ratings today released its annual update and analysis of Fitch's U.S. collateralized debt obligation (CDO) rating transitions over the eight-year period, beginning Jan. 1, 1995 and ending Dec. 31, 2002.

In 2002, CDO downgrades ran well above historical levels and were prevalent across every rating category. Approximately 8.7%, 11.3% and 22.6% of 'AAA', 'AA' and 'A' rated CDO tranches, respectively, were downgraded over the course of the year....
'Downgrades in 2002 were at least double 2001 levels and generally exceeded average annual downgrades for the period 1995 - 2001 by a margin of at least three times,' said John Schiavetta, Managing Director, Credit Products, Fitch Ratings. Fitch calculated a CDO downgrade to upgrade ratio of 14.3 to 1 for the year.'

It's not like we haven't seen this happen in other sectors.

'Structured finance CDOs accounted for 84% of all U.S. CDO in the first half of 2005, according to a recent report by Moody’s.

The negative credit migration in the “resecuritization” CDOs has been creeping up over the last several quarters, particularly for the 2000 and 2001 vintages with significant exposures to manufactured housing ABS, [et al] ...collateral quality has deteriorated ...while over-collateralization declined to below 100%. These deals are likely to suffer further deterioration in the future...'

Gee, I wonder if CDOs might get downgraded on a pretty regular basis?

In other news, I expect the Giants will beat the Pats by 3 points, and the bookmakers are either incompetent or dishonest for making them 12-pt underdogs.

ps Milken was proven right that a diversified portfolio of HY-bonds would outperform a portfolio of IG-bonds. It's trivial to prove or look up. That doesn't make it a 'free lunch,' just a fact of the markets.

Analyst,
Hold on, you read Anonymous's posts? You think they are all from the same person? I'm hoping that was supposed to be a joke, because there is no way you are really that dumb. I hope? What are "knowledgeable market savvy enters"?

1) I DO NOT believe there was a conspiracy or even intentional wrong-doing by the ratings agencies. I simply believe that we got where we are today due to a distortion created by the regulations. By forcing the ratings agencies to "bless" securities they simply created a new principal-agent problem.

2) @miami: hmmm...higher reward for equal or less risk? That sounds like the definition of an economic free lunch to me. Generally "it's trivial to prove or look up" is not a very good rhetorical device. It's kind of like saying "it's been said that shark's can heal AIDS by looking at you"; I'm sure it's been said, but that doesnt make it right. But i will agree that Milken was right at the time, and would probably be right now about diversified junk bonds. The irony of it is that is was the regulation that forces junk bonds to have lower demand (by removing regulated institutions from being able to purchase them) should theoretically increase the yield discrepency. However, when HFs came onto the scene en masse to bid up the junk bonds (bc they are not required to hold IG paper) they actually bid up the prices so much that they were trading at rediculously low yields compared to their risk. I once spoke with John Angelo (a distressed bond "king"), who, when asked "isn't this (gov't prescription to the S&L "scandal" essentially a structure set up so that you can steal money"? His response, "shhh, don't tell anyone".

Please note i dont mean "steal" to imply fraud.

Rating agencies were heavy data dependent especially backward looking data and when people/mortgage brokers committed fraud in the paperwork, it is hard to quantify human factors. Also, Rating agencies are used to get an assessment of default risk, not market or pricing risk.

1-2,

IN RE Part 2 above:

You should do some research on 'portfolio theory'.

@Markowitz: how? Risk and return are inversly related in modern portfolio theory. Thus you theoretically can't get more return for equal or less risk; it should be arbitraged away by other market players. That doesnt mean inefficiencies can't exist, but portfolio theory and strong EMH says they don't. Structural mechanisms (regulations) are one of the primary ways innefficiencies are created--but EMH says they won't persist for long.

Perhaps i mispoke, but i'll be damned if i don't know portfolio theory.

1-2 You don't know portfolio theory. You proved it twice here today.

Also, Harry Markowitz (the father of modern portfolio theory) held a portfolio consisting of 50% stocks and 50% bonds because he "could not bear the regret [he] would experience if one market ran and the other didnt". He, the FATHER OF PT, was minimizing regret and not maximizing returns.

How do you like them apples.

1-2 You're giving us the Cliff notes version, which we've all read. You should stop before you make yourself look even more foolish.

to a certain extent, and this is just a thought, one could argue that the pricing difference is at least in part just based on liquidity to wit a "AAA" cdo simply was not as liquid as a treasury, GSE debt, etc, and a rational investor would demand a premium over other AAA paper just to pay for illiquidity, just as many other AAA products trade at substantial premium to the risk free rate and even outside of swaps.

after all, rating agency is not interested in pricing or liquidity, this is just a measure of default risk, collect your coupon and principal and move on. i would think it is difficult to parse out the liquidity premium that was built in but i am not an expert in that field by any means

actually i guess you could just look at the basis and that would give a decent answer as to what the credit premium vs liquidity premium is implied

I'll take two ounces of the premium off the top shelf, with a bit of ice.

@1-2: I think alot of what you're saying makes sense, but the assumption that strong EMH holds is retarded.

@11:59: Which part of portfolio theory did he completely f' up? I'm not defending him as the jedi f'in master of it, but please, enlighten us with your wisdom.

Wait, you're telling me that there's more than one "Anonymous?"

I just thought he was a really prolific commenter.

s75 - You are of course correct that AAA-rated CDOs had a negative liquidity premium when compared to USTs. Some investors learned from the Danish Mtg debacle and others too numerous to name.

And, some investors remembered that a whopping NINE percent of AAA-rated CDO tranches had been downgraded a whole 5 years earlier.

1-2, you are too dumb for words. Saying you can look something up isn't a 'rhetorical device,' it just means I'm not going to prove pi is > 3.0, or that the sun is shining overhead if you can just look at your window and see that it is true.

@1-2 Strong EMH is BAAAAD. EMH is better than all other possible interpretations, but it needs to be the weak form, since not all utility is readily apparent from basic quant screens. Strong EMH works when you introduce all the other insane exogenous crap that comes from politics/fashion/emotion/psychology, but since that's slightly hard to quantify, and isn't easily called up from a basic financial database, weak EMH is the only thing that works.

Further, you discuss the entire point as to why such discontinuities can exist for a long time. Regulations, time preference, and psychology keep people from very attractive investments, as does the nature of some transactions/investments. Endowments made killings on VC/PE/Timber because they were amongst the few who could meet the minimums and have infinite time horizons.

CDOs and other collateralised securities make for more transparent, efficient markets. This is the same reason why Index and commodity ETFs are good - they solve the access problems for many classes of investors who need small minimums and/or high liquidity.

@Anal_yst the part of portfolio theory that he totally f'd up was Strong EMH. Otherwise I'm sure he knows what he's doing. Pretty sure 11:59 doesn't know enough to call BS on how people employ EMH.

@Miami
Thanks for the love. You must work for DB Alex Brown, what with your infinite wisdom n all. Instead of dodging your own claim again, please enlighten me. I've admitted I was wrong before and will gladly do so again. Just show me.

@Analyst + BB
I'll agree the strong-form EMH doesn't really hold up, and weak-form is a much better flavor. Perhaps in all my ferver this morning I should have made the distinction. My earlier posts certainly capture what i intended to say, but after reading them were pretty much drivel. Apologies.

@haters (ie, "11:59")
Please enlighten me as to how I have proven i dont know MPT. As i said above, I'm happy to admit it when I'm wrong.

@BB - In retrospect i agree with what you're saying. I really mixed two different arguments into one and it came out a jumbled mess.

You are all mixing EMH and MPT.

One deals with assets, the other with portfolios.