Give the Lady What She Wants

The graph above is from a post at FT Alphaville that Tyler Cowen has characterized as “the most important blog post in the world today”. From the post:

The financial crisis had a lot to do with triple-A ratings being slapped on to subprime securities which didn’t warrant them, we know that. The report says between 1990 and 2006 ABS accounted for 64 per cent of the total growth in the amount of AAA-rated fixed income, compared with 27 per cent attributable to the growth in public debt, 2 per cent to corporate and 8 per cent to other products.

But watch what starts happening from 2008 and 2009.

The AAA bubble re-inflates and suddenly sovereign debt becomes the major force driving the world’s triple-A supply. The turmoil of 2008 shunted some investors from ABS into safer sovereign debt, it’s true. But you also had a plethora of incoming bank regulation to purposefully herd investors towards holding more government bonds, plus a glut of central bank liquidity facilities accepting government IOUs as collateral. Where ABS dissipated, sovereign debt stood in to fill the gap. And more.

Felix Salmon interprets the enormous growth in AAA bonds:

The big-picture thing to remember when looking at this chart is something which I’ve said many times before — that it wasn’t an excess of greed and speculation which led to the financial crisis, but rather an excess of overcaution, with an attendant surge in demand for triple-A-rated bonds. On a micro level, triple-A securities are safer than any other securities. But on a macro level, they’re much more dangerous, precisely because they’re considered risk-free. They breed complacency and regulatory arbitrage, and they are a key ingredient in the cause of all big crises, which is leverage.

Yves Smith is contemptuous of that explanation:

Now anyone who had read the Financial Times in 2006-early 2007 or was in the credit markets then would know that this statement, “it wasn’t an excess of greed and speculation which led to the financial crisis, but rather an excess of overcaution” is demonstrably counterfactual. All you had to do was look at the spreads for risky assets. There was a simply astonishing compression between the yields of perceived-to-be-risk-free assets, such as Treasuries and their toxic counterfeits, the AAA rated tranches of CDOs and CLOs, and risky assets, like the lower-rated tranches of the same bonds, as well as junk bonds. If there was “overcaution” you would have seen a wide spread between AAA bonds and lesser-rated bonds.

But to Felix’s point, demand for AAA paper was robust. But that was not the result of caution; two big drivers of demand (particularly for “manufactured” AAA paper, the kind created by structured credit legerdemain, was as repo to serve as collateral for OTC derivatives positions, and for bonus gaming. In the 1980s, the ONLY acceptable collateral for repo was Treasuries; that started expanding as time went on to other AAA rated assets (and even lower rated assets, but the haircuts were significant).

[…]

I have a sneaking suspicion that while derivatives outstandings took a hit in the crisis, between a rise in risk aversion and a concerted effort in credit default swaps land to reduce the notional amount outstanding by netting out offsetting positions, that the old pattern of derivatives outstanding growing more rapidly than the economy has resumed. And now that no one is terribly interested in using AAA rated CDOs as collateral for repo, Treasuries are probably even more important as repo collateral than they were before the meltdown.

A second, significant demand for AAA rated paper was structured credit product creators uncharacteristically eating their own cooking because it enabled them to game their firms’ bonus systems. If you hedged an AAA instrument with a credit default swap from a high rated counterparty, Basel II allowed firms to treat it as having no capital requirement (and there was considerable latitude in the rules as to how much or little hedging was necessary to achieve this happy outcome). US banks in theory had analogous capital weightings, but their higher funding costs for this sort of activity and less permissive treatment of the hedges meant they didn’t do this sort of trade in anywhere near the same volume (save at Merrill, which engaged in accounting chicanery).

The net effect of these so-called negative basis trades were to allow the trading desks to credit FUTURE income (often years into the future), namely, the yield on the instrument less the funging and hedge costs, discounted to the present and was credited to the desk’s P&L. Nothin’ like getting paid on income never to be earned.

I see this as very compatible with Arnold Kling’s reaction:

The nonfinancial sector wants to issue risky long-term liabilities and to hold safe short-term assets. The financial sector accommodates this by doing the opposite. But sometimes the financial sector gets too big. The financial crisis was a signal that the financial sector needed to shrink.

It didn’t.

Assuming the facts of the graph are correct, I see several possible interpretations:

1. There’s an enormous volume of legitimate AAA bonds out there.
2. In response to the financial crisis governments have borrowed a lot of money to offset the decline in asset-based securities and it’s legitimately rated AAA.
3. Like good courtiers the ratings agencies have continued to grant AAA ratings to government debt whether it warrants it or not, cf. Moody’s recent threat to downgrade the U. S. The party will go on for a good, long time.
4. Borrowing will soon become much more expensive.
5. Yves Smith’s explanation.
6. Some other explanation (if you’ve got one please supply it in the comments).

Or some combination. Tyler Cowen summarizes the situation: “We weren’t as safe as we thought we were. And we still aren’t.”