Here we go round again

Here is a good paper from HBS on structured finance. It is a good summary of how and why the market works and why it went wrong and we ended up with a credit crisis.

What is particularly striking is how the previously rare and highly coveted AAA-rating became a common currency through structuring and securitisation, and what should be plain, though is scarcely stated is/was the way banks structured their deals to fit the valuation models of the rating agencies. I have previously written about the distortion in the market for banking assets caused by ratings based allocations of risk capital, but this paper shows how the demand was satisfied from ratings models based on possibly questionable assumptions about default risks and correlations.

I could go on for hours about the differences between purely quantitative ratings from structured finance based on expectations of default and the more qualitative ratings that were formerly appiled to single counterparty issuers. In the past if a rating agency passed judement on the quality of the manaement of a major company or the political risk or quality of the markets in which it operated by tweaking its rating, it was enerally accepted as a fact of life, but in the ultra quantitative world of structured finance, the focus is entirely on statistical risks, and the quality of the outcomes is as reliable as the quality f the assumptions.

Anyway, that is not what we are writing about today. Suffice it to say that the origins of the credit crisis can be traced to a lot of repackaging of assets of questionable quality into securities that were rated AAA, and that when the wind started to blow in the wrong direction, a lot of those assets were downgraded, meaning first of all that many of the holders lost a lot of value, and secondly that many funds and other investrs who were mandated only to hold AAA paper were left holding a lot of depreciating assets that they had to sell, leaving probably trillions of crummy paper overhanging the market with few buyers.

So it was only a matter of time before some bright spark had the idea of buying up a lot of the devalued paper, and you guessed it, top slicing it to make repackaged AAA paper to sell into the markets. The ratings agencies, seeing a fall in primary and even secondary issuance, are more than happy to slap a AAA ratings sticker on any new issues that give the right numbers on their spreadsheets, and the issuing banks are no doubt making fantastic trading profits, buying in the low value paper in a moribund market and making a spread when they sell the top slice out into the AAA market.

We are seeing the same crummy game played out all over again, and none of the regulators are batting an eyelid because its suits their purposes not to do so. It's like buying in a mouldy fruit cake, scraping away the more obvious bacterial infections and putting the rest back on sale as new fruit cake.