We must, said Greg Newton earlier this week, stop calling this a subprime problem. It is a leveraged, mostly-mortgage backed complex derivatives problem.
Take a look at this chart, from Markit.
Familiar? Of course, it’s the toxic tranche – the BBB- rated bonds, the junkiest tools in the RMBS box.
But clambering up the value chain and what do we find?
The kind of gradient that induces vertigo in even the most robust of investors. And that’s at AAA. At AA, it’s a similar story – only worse.
Barry Ritholz, at the Big Picture, wonders:
On the train home, I bump into a friend from UBS, who reminds me that triple AAAs contains up to 8% toxic sludge, while the double AAs contain up to 12%…perhaps the focus has been in the wrong place — not the low quality junk, but the supposed AAA stuff.
Readers at the Big Picture are agog. The AAA bonds are the top of the pile, and should only default if the lower tranches hit zero.
One comment suggests that these moves are factoring in upwards of 60 per cent defaults in subprime lending.
Another agrees, but adds that what is amazing is that this is a real possibility:
The quality of the loans is overstated, IMO. Calling them toxic waste is an insult to real toxic waste. Most of these loans are not much better than a made-up name on an application.
The Economist points out that, the trouble is, we’ve previously been lead to believe that AAA actually means something. The more As the better.
Only six US non-bank companies carry a triple A rating, according to S&P, including Berkshire Hathaway and General Electric. The perceived value placed on an AAA label has been enhanced by scarcity value.
But in CDOs, the AAA rating denotes a repackaging of risky loans in a way that makes default an extremely low mathematical probability.
The ratings agencies, says the Economist, have done well from rating structured products – but may have inadvertently undermined their own gold standard.