In my previous post (Wonderland), I asked what sort of evidence justifies making public sport out of the major bond rating agencies and their role in the recent financial crisis. The type of sentiment I question was repeated the other day by Paul Krugman here; I quote:
And S&P, along with its sister rating agencies, played a major role in causing that crisis, by giving AAA ratings to mortgage-backed assets that have since turned into toxic waste.The first thing we have to ask, of course, is what does a AAA rating actually mean? The only thing most people know is that AAA is the highest rating that agencies attach to bonds. But that's an ordinal statement; it does not necessarily imply "absolutely free of risk." Apart from death and taxes, there are no perfect guarantees in life.
The second thing we have to ask is what sort of risk are the ratings trying to measure. In a nutshell, they measure the risk that the terms of a contract are not fulfilled. They do not measure the liquidity risk associated possession of the asset (the major problem during the financial crisis). Note: by liquidity risk, I mean the ease with with one can dispose of an asset (or use it as collateral in a loan) over a short period of time, without the asset being ridiculously discounted in the market.
Now, there seems to be no question that in the depths of the crisis, a lot of MBS was treated as if it were toxic (it was heavily discounted). But as I said above, bond ratings do not (I do not think) measure liquidity risk. They measure things like, well, did the MBS actually deliver on the interest and principal that was expected?
It surprising how difficult it is to find out just how much of the outstanding MBS actually did end up as toxic waste. Paul Krugman seems to think it was a lot. So do a lot of other people. But where is the data?
I decided to ask Gary Gorton, who knows more than most about these matters. Here is how he replied to me:
Of the notional principal amount of AAA/Aaa subprime bonds issued in the years 2006, 2007 and 2008 (which is almost $2 trillion), the realized principal loss as of Feb 2011 is 17 basis points – almost nothing, but much higher than AAA/Aaa other stuff. Yes, I think the agencies are being treated unfairly by uninformed people. There are many other facts that are similar that are also inconsistent with the popular narrative of the crisis.If this is true, it is indeed remarkable. The actual losses on these "toxic" products has been tiny. That is the type of risk that was being evaluated. (I might add that the losses on bank deposits during the great financial panics of the U.S. National Banking Era (1863-1913) were reportedly in the order of 50 basis points.)
Evidently, Gary has a PhD student working on this. I look forward to reading her findings (and reporting them here). Of course, if anyone out there has evidence relating to this question, I'd greatly appreciate hearing from you.
Update: August 10, 2011
Thanks to Jesse for this link to Bond Girl, who makes a lot of the same points (and more).
I also received this note from Don Brown (thanks, Don--I will investigate):
I cannot verify current loss=17bp figure, but it doesn't sound surprising to me. HOWEVER, that misses the point. There are significant losses to be taken on 05-07 vintage subprime, due to massive delinquencies. It will be on the order of 12-15% of the original amount of AAA subprime securities that FNMA/FHLMC bought. I encourage you to do your own original research to verify this, but as a quick back-of-the-envelope:
I know that agency portfolios were buying wide-window AAAs off subprime, mostly 06-07 vintage. They bought a lot ($250B if I remember correctly). Note: portfolios were the hedge funds that FN/FH were running, outside of their traditional business as mortgage guarantor.
Average original subordination was 26-30%. So actual losses on subprime would have to be around this level to start showing losses. Currently, actual losses aren't at this level, but it's easy to see that they will increase (barring a miracle).
To date, most subprime deals have taken losses in the 15-20% range (percentage of original balance). They have serious delinquencies 40-60% of current balance (serious dlq defined as 90+ days dlq, FCL, or REO).
15% current losses leave you with 11-15% subordination (on average). Currently, subprime loss severity is around 80% (upon liquidation of the house). For a 50% dlq deal => 50%x80% = 40% additional losses from here (distributed over time). That would imply actual losses of 25-29% on the current face of the class. Average factor for these classes are 0.55. Very roughly, this translates to 12-16% loss on the original investment.
For examples, take a look at OOMLT 07-5 1A1(cusip 68403HAA0) and CWL 06-26 1A (cusip 12668HAA8). One of the agencies owns these classes (almost all subprime deals have a Group1 / Group2 structure. Group1 was conforming balance subprime loans that went to the agencies). You can find the remittance reports at BoNY web site or CTS. They are publically available.
Update: August 14, 2011
Rebel Economist (see comments below) directs me to this interesting link: Is Blaming AAA Investors Wallstreet Serving PR?