AAA ratings

This chart is making the rounds of the professional commentariat.

I don’t generally comment on stuff like this, but I think everyone is missing the point (especially Felix Salmon).

The chart shows that AAA ratings accounted for an ever-larger portion of total ratings leading into the crisis. One other thing was going on during that time, namely that credit standards were rapidly deteriorating.

Thus, the percentage of issuances rated AAA were increasing as the assets backing the issuances were of decreasing quality. IMHO, if you can explain how this seemed reasonable to the best and brightest, you can explain the crisis.

Understanding all this is important now, because the official narrative of the financial crisis is still being written.


3 Responses to AAA ratings

  1. Handle says:

    Normally I’m a big fan of Sumner, and I completely agree with his proposal for NGDP level-targeting at the Fed, but I think his housing-bubble analysis is way off. Even his own commenters push back against his views on the EMH and bubbles, and I don’t think his “purely-NGDP” version of the crisis narrative withstands scrutiny. I’ve yet to see a compelling case against what is a very simple vicious-cycle feedback-loop classic tulip-mania mechanism as follows:

    1. Underwriting standards gradually declined. (Credit Scores, NINJA – No Income, No job, No Assets, No documents, etc.)
    2. New Debt Issuance Exploded
    3. Asset Prices Appreciated
    4. Expectations set in for the continuance of future appreciation which exceeded interest rates (see Kling for more on this)
    5. Debt-financed Speculative Short-Term Flippers enter the scene (this, to me, is the quintessence of any bubble phenomenon)
    6. Financial Securitization, CDO’s and Synthetics, and the Originator-immediately-distributes all risk opaquely to some clueless fund-investor model expands
    7. Even people who stayed in their homes could “Refinance” and bring forward the capital-gains with MEW and spend it now – boosting consumer consumption.
    8. Huge numbers of people attracted to becoming Realtors and using huge commissions to boost consumptions.
    9. Significant attraction of developers and an increase in construction and speculative new-home-building activity.
    10. Lather, Rinse, Repeat 1-9, until …

    Until you’ve issued a 125% LTV 6-month teaser Option-Arm to an illegal-immigrant landscaper who earn $14K a year trying to buy a rotting shack in Compton for $800,000 (see Dr Housing Bubble) and he defaults on his first payment. That is, in other words, you found the “last fool” in your Ponzi/Madoff Scheme which is utterly dependent on new-entries to sustain its froth.

    This began to occur (and was noticed by GS analysts) as early as the bubble’s peak – in 2006. That’s the point at which you’ve reached the market’s capacity for expansion and prices can no longer rise no matter what you try.

    And then you tell the whole doom-loop story which occurs when prices begin to fall back to their historical ratios. The financial crisis and liquidity crunch was just a symptom of what everyone knew were going to be tremendous losses in the system and investment instruments they deluded themselves into believing was AAA-secure. (As an aside: Given the statistical definition of AAA – I think that from a purely mathematical standpoint there is a theoretical limit to the actual amount of AAA which can be issues, and if you exceed that limit, someone is getting fooled as to the quantity of real resources actually available to pay off all the debts.)

    Then they send out the orders to stop issuing new insane first and second mortgages and refinancings. This did two things – it immediately arrested the huge MEW cash engine which was driving fully a tenth of consumption, and falling prices put a lot of people who thought they were rich into actually being underwater on their loan. I think that’s what killed NGDP – not the other way around.

    Now, what’s wrong with my narrative?

  2. B D says:

    “how this seemed reasonable to the best and brightest..”


    They test the brightest. If character and judgment counted in their class (it doesn’t) they are far from the best.

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