CONVEX COMBINATIONS

A recent Bloomberg article suggests that the rating agencies are still making mistakes.

Standard & Poor’s is giving a higher rating to securities backed by subprime home loans, the same type of investments that led to the worst financial crisis since the Great Depression, than it assigns the U.S. government.

S&P is poised to provide AAA grades to 59 percent of Springleaf Mortgage Loan Trust 2011-1, a set of bonds tied to $497 million lent to homeowners with below-average credit scores and almost no equity in their properties.

Treasuries gained about 1.95 percent and U.S. borrowing costs have fallen to record lows as investors repudiated the downgrade, according to Bank of America Merrill Lynch indexes. S&P has awarded AAAs to more than $36 billion of securities in the U.S. this year that were created by bankers who continue to gather thousands of loans, bundle them into bonds of varying risk and pay ratings firms a fee to assign credit rankings.

The article continues by reminding readers of recent history.

Securitization enabled by S&P contributed to more than $2 trillion in losses and writedowns at the world’s largest financial institutions and the collapse of Lehman Brothers Holdings Inc. three years ago, causing credit markets to seize up and leading to the global recession. 

A report by the Senate’s Permanent Subcommittee on Investigations said that S&P, Moody’s and Fitch Ratings helped trigger the financial crisis when they cut thousands of mortgage securities they rated AAA to junk status. The raters had engaged in a “race to the bottom” to win business, lawmakers said. 

Bank of America Corp. and Royal Bank of Scotland Group Plc sold $242.7 million of the Springleaf mortgage bonds today that are set to get S&P’s top ratings, according to people familiar with the matter, who declined to be identified because the terms haven’t been set. 

The transaction was reworked after marketing began to give those securities more protection against losses than S&P required, a sign investors may not have trusted the grades. An additional $49.7 million of the deal ranked AAA that will suffer losses first was split from the rest and not sold. 

The safer debt was sold at a yield of 4 percent and has a projected average life of 2.44 years, one of the people said. That’s about 20 times the rate demanded on two-year Treasuries.

There's probably a dissertation waiting to be written about the nature of investor demand for low-risk assets.  Today's Book Review N^o. 28 considers Reckles$ Endangerment: How Outsized Ambition, Greed, and Corruption Led to Economic Armageddon.  The book has received some play, perhaps excessive play, on the right side of the Internet for assigning responsibility for the housing bubble to public policies that encouraged unwise borrowing and lending.  And yes, some members of Congress were excessively optimistic about the government sponsored lending agencies.  The more intriguing parts of the story, however, are in the emergence of mortgage-backed securities as gilt-edged investments.  Reckless Endangerment suggests a connection (never explicitly ruled out as a coincidence) between the brief interlude of Federal surpluses and the interest in convex combinations of mortgages as a safe asset. That demand has to be meaningful: many of the advocates of greater spending on infrastructure note the willingness of people to hold government bonds, Standard & Poor downgrade or not.

There's still a part of the story I don't understand, though.  The banking houses and rating agencies allegedly created these mortgage-backed securities as a way of generating underwriting fees.  General Sherman's observation about military logistics keeps bothering me: "No army dependent on wagons can venture more than 200 miles from its base, because the teams in coming and going consume the contents of the wagons."  No matter how one slices and dices portfolios of mortgages, the fees in slicing and dicing consume the contents of the principal and interest payments, and the book helpfully explains that mortgage portfolios are subject to three kinds of risk: the risk of default, which is salient in portfolios of subprime mortgages; the risk of interest rate changes, which an adjustable rate mortgage attempts to counteract; and the risk of early prepayment, which some homeowners attempt to do as a form of forced savings, and which some of the irregular lenders attempt to prevent in a number of ways.

The villain of the piece?  Precisely those banking houses.  Turn to page 274.

The voraciousness of these firms would also push the nation's economy into its most serious recession in more than seventy-five years.  Their avarice would finally, and forcefully, demonstrate how a noble idea like homeownership could be corrupted into something that so poisoned the global economy it was left in a semi-vegetative state.

Never mind the mixed metaphors.  Something went wrong, and there's plenty of blame to go around, and yet, the securitization beat goes on.

(Cross-posted to 50 Book Challenge.)