Parts of that is right, but I think you mis-state a lot of the ratings stuff.
The fundamental idea behind the ratings is (simplifying a lot) that you could take a lot of crap mortgages and then slice them into tranches, assigning losses to the lowest tranches first, and to the highest tranches last. So if you have 1000 mortgages, and you slice it into 10 tranches of 100 each, and 250 mortgages go bad, then the lowest two tranches lose 100%, the next tranche loses 50%, and the top 7 tranches lose 0%. What the ratings agencies were doing by assigning AAA grades to the top tranches was estimating the likelihood that EVERYTHING would go bad was very low.
And what I think a lot of people miss about the financial crisis is that this was not wrong. Not only was it correct in principle, but actual losses on AAA rated securities was extremely low because even among subprime a lot kept on being serviced. So the ratings agencies said "hell, we could have a massive crisis and these top tranches will still mostly pay out", and then we did have a massive crisis, and those top tranches still mostly paid out.
There were a lot of issues and problems and corners cut and bad paperwork and robosigning and a hundred and one other scandals, some quite significant. However when you say:
> They had assumed that "AAA" would remain relatively safe.
It's worth remembering that this assumption was shown to be correct! From the financial crisis inquiry report:
"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."
On the other hand, something like 95% of lower rated tranches ended up suffering losses. The tranches were a mechanism for concentrating credit risk in the lower tranches; the problem isn't that it didn't work, but that 1) it worked really well and 2) everyone was badly underestimating the total about of credit risk in the system. AAA was mostly fine; everything short of AAA was absolute toast.
(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.)
> "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.
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.
> 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.
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.
> From where I stand, there is a compelling, coherent story of people being idiots, but the cynical, blatant corruption seems missing.
Yeah, like I said, its closer to opinion than verifiable fact.
However, the paper basically admits the facts I use to conclude that are correct but draws the opposite conclusion by comparing incestuously rather than across verticals.
Yes, relative to other mortgage related things, the ratings were correct but such ratings are published as absolute probabilities and not as relative assurances that AAA > AA > A > BBB. The fact the absolutes were in error for a single portion of a single vertical among multiple firms implies its an incentive problem which the paper agrees. It just draws the line in a different place because its analyzing a different question [Insiders vs. Outsiders rather than Insiders vs. Insiders].
> The answer may well involve the information and incentive structures present inside Wall Street firms. Employees who could recognize the iceberg looming in front of the ship may not have been listened to, or they may not have had the right incentives to speak up. If so, then the information and incentive problems giving rise to the crisis would not have existed between mortgage industry insiders and outsiders, as the inside job story suggests. Rather, these problems would have existed between different floors of the same Wall Street firm.
The paper believes its internal to the firms but the uniformity of the problem between firms implies it was the culture of all the large firms and likely exported to the credit bureaus due to heavy competition in a single vertical. The difference between what the paper is arguing vs. what I'm arguing is likely impossible to determine because of the incestuous movements between those firms and even the credit bureaus of the human capital involved.
The fundamental idea behind the ratings is (simplifying a lot) that you could take a lot of crap mortgages and then slice them into tranches, assigning losses to the lowest tranches first, and to the highest tranches last. So if you have 1000 mortgages, and you slice it into 10 tranches of 100 each, and 250 mortgages go bad, then the lowest two tranches lose 100%, the next tranche loses 50%, and the top 7 tranches lose 0%. What the ratings agencies were doing by assigning AAA grades to the top tranches was estimating the likelihood that EVERYTHING would go bad was very low.
And what I think a lot of people miss about the financial crisis is that this was not wrong. Not only was it correct in principle, but actual losses on AAA rated securities was extremely low because even among subprime a lot kept on being serviced. So the ratings agencies said "hell, we could have a massive crisis and these top tranches will still mostly pay out", and then we did have a massive crisis, and those top tranches still mostly paid out.
There were a lot of issues and problems and corners cut and bad paperwork and robosigning and a hundred and one other scandals, some quite significant. However when you say:
> They had assumed that "AAA" would remain relatively safe.
It's worth remembering that this assumption was shown to be correct! From the financial crisis inquiry report:
"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."
On the other hand, something like 95% of lower rated tranches ended up suffering losses. The tranches were a mechanism for concentrating credit risk in the lower tranches; the problem isn't that it didn't work, but that 1) it worked really well and 2) everyone was badly underestimating the total about of credit risk in the system. AAA was mostly fine; everything short of AAA was absolute toast.
(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.)