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Inflated Bond Ratings Helped Spur the Financial Crisis. They’re Back (wsj.com)
298 points by chibg10 on Aug 7, 2019 | hide | past | favorite | 228 comments

There is so much armchair theory and bullshit surrounding economics (especially in the news) that it's hard to tell what's valid anymore.

The article isn't really making a prediction (though the headline spins it as if it might). It's pointing out a pretty obvious and easily understood conflict of interest in the way the bond rating market works. When rating packaged debt, the rating companies are not being "hired" by the end investor who will bear the risk, but by a middle-man firm who are creating the security and trying to unload it. So the rating firm only gets hired if the packager thinks they'll rate the security highly.

That's a real problem, and needs to be solved. It's not by itself a trigger for a financial crisis, though it's not hard to imagine it becoming one.

> middle-man firm who are creating the security and trying to unload it.

If the investment bank only facilitates the transaction, then the key incentive that could tilt the transaction toward having a sense of urgency, and as a result, indifference to the rating accuracy would be the personal gain of the individual/team attempting to process the transaction.

If that assumption holds, would tying in a performance based return to the banker who sells the security, balance it? That way they also have incentive to make sure the rating is as accurate as possible?

If so, then it seems that it would probably be resolved through legislation, because otherwise it appears to be an intractable coordination problem. Unless including a return for the seller based on the performance is something that occurs in the industry for other types of securities.

Exactly, and without taking anything away from the article: this is not a new insight. From the moment it became clear what were the main causes of the financial crisis, there have been plenty of people pointing out that practically nothing was done to actually address them.

Of course not. Because up until the bottom falls out, a few people are going to continue to make tons of money.

Potential bond buyers are free to pay an independent third-party service for an independent rating if they want it.

There is no practical way that I can make use of the availability of such ratings to protect myself (let alone others) from the damage to the economy that is being caused by the conflicts of interest being described here.

How do I get my employer-provided-pension fund to do this, when they depend on these rating agencies to ensure they only invest in safe, AAA rated securities?

Do you know if they do it?

Big investors do it. They contract independent firms to double-check their own traders' thinking and decisions.

It's usually not proactive though. (PE firms get valuation checks before investment, but that's different than bonds.)

Sounds like a problem with (this type of) bonds in general as a financial instrument if their pricing is not contingent on actual market forces but rather the word of an expert.

they are priced based on the market, but rated by an agency. bond pricing is easily understood math.

People just trust the agencies when they rate bonds highly, even if they shouldnt be

Why not have legislation similar to what enables the credit-rating agencies to report on people’s credit habits on the securities industry?

If that's the case, why market hasn't managed to solve it?

Rating agency who's customers pay a subscription price for receiving rating, should solve it?

Markets only function well to some extent. Just having a market does not mean that you have a system that solves all pricing problems.

Your assuming markets are perfect - they aren’t

For each product needing to be rated, there's one seller and potentially many buyers.

Sellers need to convince buyers to buy their product. Sellers need to get their product rated in order to appeal to buyers. It's a one time cost to the seller to appeal to a large amount of buyers, and the higher the rating, the larger the pool of potential buyers.

Flip it around. How do you coordinate enough buyers together to pay for rating all the potential products out there to buy?

Yes, you are right. Also because rating can't be kept private, so there is no reason for any buyer to subscribe and then rating agency isn't viable.

As ajross says, there is a conflict of interest here. Not everyone wants an unbiased rating.

2008 provided strong empirical evidence that the market does not have the motive to solve its own problems. Markets are not obliged to conform to theories about how markets should work.

Valid is hard to tell in economics, because economics isn't really a science. More of a social science. A lot of people have debated this point before, but even at a theory level, it imagines people as rational actors, and we know they are not always, and sometimes not ever.

Economics, and social sciences, are still sciences. It's just not as clear cut as say, physics or mathematics. A lot of the interesting parts of economics are how to build models that accurately predict human behavior.

In aggregate, it sometimes makes sense to model participants as rational, but this is a very simplistic model that does not always apply. There are lots of economists studying how asymmetric information or irrational participants can cause market failure or other outcomes.

To me, economics being a "science" implies the use of the scientific method.

You cannot study economics in a vacuum...in other words you cannot conduct the "test" part of the scientific method, because the real world will always produce some other unknown imperfect variable that affects the theory.

This is why behavioral economics are so important. IMHO it's the first truly concerted attempt at isolating economics to its core science in a repeatable and testable form (albeit not perfect). For example - understanding things like anchoring, recency bias, nudging, etc.

Supply and demand is more core than anchoring and it was certainly discovered earlier.

It's tested all the time.

Add tariff, demand drops. That's also economics and works well in 2019.

This stuff is now so obvious we've forgotten it and can now argue about whether economists can predict recessions.

The usual "supply and demand" rule doesn't even work consistently. See Veblen goods for a counterexample.

So it's hard to see economics as a valid science. There are no consistent theories and exceptions to everything.

This is a misunderstanding of what “science” is. Your objection is that the theories of economics are not correct enough for it to be a science. How is this argument not also true of, say, chemistry? Every simple theory in chemistry has a number of exceptions, with a more complicated theory waiting in the wings, up to the limit of our understanding.

“Science” is not some kind of shorthand for “ultimate understanding of the world”. It is just a process for validating and understanding the limitations of theories.

The difference is that basic chemistry is fundamentally reliable. Basic economics is hand-waving and just-so stories and "Yes, but..."

Absolutely no theory in economics passes even the most basic quantitative testing.

Really. That is an observable fact. It's not an opinion.

Empirical economics is barely even a thing, and even when it's a thing it's mostly nonsense, based on poor data and questionable methodologies.


Econ is a bit like medicine. You can not really brute force things. Even phase 3 clinical trials are just a very crude and low entropy source of data.

That does not mean there aren't theories, hypotheses, experiments (usually natural experiments, or small scale pop psychology demonstrations like the dollar auction), and so there is data and you can fit models.

And in economics the hard part is getting good quality data, knowing what to try to quantize, where to start. Some folks spend decades hunting for signal. And then we get priming, and turns out it was nothing. At the same time there's SBTC (skill-biased technological change) the theory describing what happens as automation progresses. But it takes a lot of work to correctly "apply" that theory, because the effects are complex, and you have to keep in mind what else can also affect your observables. (So confounders has to be managed.)

And in the end we get high quality insights, such as the David Autor paper (Why there are still jobs?).

And there are the long and even deeper dives like the "Why nations fail?" book, which talks about the problem of public choice economics (politics) and how to model good politics, how to measure, how to quantify, etc. It's naturally less dense than a paper, but the problem and the pondering is a very important part of science. (The hypothesis generation, the abductive reasoning part.)

Very thoughtful comment, thank you. Indeed the main difference between e.g. physics and economics (or medicine) is that in the former case one has the privilege of being able to experiment by toggling the parameters one at the time. And brute force things with experiments, as you write.

And isotropy of the universe. Okay that only helps on the really large and really small scale But the fact that regular Newtonian physics works so well is because it's aggregated over so many particles, we are so far from the froth of the quantum world, that when designing a bridge, we can assume things, and those assumptions will be valid almost everywhere.

There's no need for correcting for local variations that are needed in econ. Or from a different perspective the fact that we have simple laws in physics, and chemistry, and engieering, is because we are only considering/using a _very_ limited part of the whole universe.

The classic CH4 + 2 O2 = CO2 + 2 H2O is a gross oversimplification, because there are a few dozen other things going on at the same time, and NASA/SpaceX/BlueOrigin has to consider those when they burn in an athmosphere. But since we rarely encounter these problems we don't often find ourselves lacking enough data to fit a better theory. (But of course that's what's happening in post standard model physics, or in cosmology, or in trying to design fusion plants, we are very early in magnetohydrodynamics, and even designing a better corrosion resistant material for use in molten salt reactors is a challenge.)

So, just as we have models for ant ecologies we have for economics of states/countries, but just as neuroscientists have trouble figuring out how exactly an ant works and when does what and where ants will go to forage next economists have trouble predicting when the next crash will happen. (See also bee hive collapse syndrome, we still don't know what causes it, yet there's a lot of hives and we could even do experiments with them easily.)

"In physics with 3 theories that can model 97% of the world. In economics you have 97 theories that can model 3% of the world."

I can't remember the source for this aphorism, but it resonates a lot with your comment :-)

[disclaimer: I'm a physicist]

What part of basic chemistry is fundamentally reliable? I would be interested in seeing an example; it would help me understand what your notion of “reliable” is. My personal experience is that there is lots of hand-waving in chemistry.

> My personal experience

Well this the point. Personnal experience is flawed and unreliable. In my personnal experience, something that weight more should fall faster. This is not the case.

Which economic theory enuce clearly the subset of conditions required to be true and fit the refutability criterion? For chemistry: all of them.

> For chemistry: all of them.

Humor me… can you give a more specific example? When I took chemistry classes I don’t remember learning a theory that was completely correct, but it has been a while.

I think the distinction is between hard and soft sciences. Hard sciences like chemistry, physics, mathematics are very reliable. Barring some very special cases (where an explanation hasn't been found yet) identical conditions will produce identical results. So they're not only reproducible but you can use one to deduce the other.

Soft science like economics, psychology, sociology will have none of the 2: conditions vary, results vary, and even if you could ensure you start with absolutely identical conditions it's very implausible that the result won't be heavily influenced later on by random factors.

I don't know about "Science", it's too broad, but a valid scientific theory must valid the "refutability" point, and not respond "this is an exception!" when this point is reached. How many scientific theories does Econ have is a much more interesting question than "is Econ a science?", at leat to me.

> It's tested all the time.

That's not testing. That's just a real life interaction. You can't isolate the variables in supply & demand, so we can only theorize that supply & demand is universally true. If I mix copper and tin in a bowl, I will infinitely get bronze as a result. This can be tested again and again with no variation. I simply cannot reproduce people's behavior in a vacuum. We can only observe it in the real world and draw the conclusion. This goes for my comments about anchoring, etc. as well.

Mathematics is not a science, and model building is not necessarily a science, either.

Additionally, a significant number of social scientists aren't scientists.

I mean... a social science is a science by definition, and making an argument successfully within those fields involves proving it via the same methods that are used in natural sciences. It's just not as easy to eliminate variables and come to clean "laws" as easily, as is possible in say chemistry or physics.

There is a lot of gray area, for example is medicine a science? Many treatments or diagnoses are based on probabilistic or empirical models -- that doesn't make them worthless.

When the comments takes only three levels to get to "what is science?"

>There is a lot of gray area, for example is medicine a science? Many treatments or diagnoses are based on probabilistic or empirical models -- that doesn't make them worthless.

Medicine is not generally considered a science.

And never was it implied that things that aren't science are worthless.

Not sure why you're getting down voted. Economics is a science, full stop.

Are group and ring theory not a science, or are they not mathematics?

For 90% of the cases that interest mainstream media, economics is not a science because proper experiments cannot be run. You cannot have clean counterfactuals and no "A/B testing" setup to validate hypothesis in most interesting cases of dramatic economic events (like a recession). Most theories end up being... theories, with weak validation based on dubious instrumental variables, if any are considered at all.

Being unable to run those sorts of experiments doesn't disqualify a field from being a Science - consider astrophysics.

I think the issue here is more that economics is describing human behaviour, and we don't fit well in to a mathematical formula.

This is exactly correct. But the issue that “humans don’t fit well to a mathematical formula” is also true of everything that you don’t describe with quantum field theory. Even chemistry is full of this.

A key aspect of the scientific method is that claims can be demonstrated to be not true (it doesn’t matter if the demonstration is done in a lab or not).

You do understand that economists run experiments all the time, right?

"even at a theory level, it imagines people as rational actors"

There is a whole field of economics ('behavioural economics') that explicitly doesn't make this assumption.

That’s the only scientific part about it but afaik it still only applies to micro not macroeconomics.

To quote Charlie Munger: “it economics is not behavioural, what the hell is it?”

Politics. Economics is persuasion. It's about some people telling other people how they should act "because".

It's not descriptive or empirical, and never has been.

The more honest economists will tell you it's considered part of moral philosophy.

I can recommend the book "Licence to be Bad: How Economics Corrupted Us" by Jonathan Aldred - it makes a pretty strong case that the way economics has influenced politics over the last few decades has had a pretty strong negative impact on society:


Moral philosophy is a part of it and how it is often used but not all of it. It is possible to be objectively incorrect and it becomes rapidly apparent.

Use fixed universal prices regardless of location and you /will/ have problems. The Soviets tried unsuccessfully to do a value calculation for their existence.

Economics points out for instance that stopping smuggling without offering an alternative serves as a subsidy for the successful smugglers.

Doing the math to point out that say a deflationary currency would eventually become worthless as a currency is likewise objective.

The problem is that this is basically all that behavioral economics is good for.

Behavioral economics is just a branch of psychology. A collection of trite rules of thumb relating to how people tend to act in certain "economic" situations.

It makes for good reading in the Harvard Business Review.

Is this true? I've tried to find more depth than this and have admittedly struggled in the past

No, it's not. longdelay has their own interests and thinks that adherence to those interests defines the value of a branch of science for everyone.

So, what became known as behavioural economics was 100% started by two psychologists, Daniel Kahneman and Amos Tversky.

While they investigated new topics (i.e. economics), their methodologies were 100% within the standard practice of social and cognitive psychology at the time.

They were then awarded the Nobel Prize for this work. Now, not everyone in the field came from psychology, but a lot did, and the methods used in behavioural economics are essentially indistinguishable from those used in psychology.

For references, Thinking Fast and Slow is probably the best source, as one of the original authors describes their research program.

I understand what you are saying, but on the other hand we don't call calculus "physics" just because it was introduced by Newton (and Leibniz, yeah yeah).

Also, modern economics use some heavy mathematical tools, yet nobody says its a branch of mathematics.

And lastly, psychology is in my opinion one of the most important branches of science right now.

I think that behavioural economics is it's own thing now, but it is heavily inspired by psychology (and, in it's turn, has helped to inspire psychology).

I agree with you on psychology's importance, but that's probably because I am a psychologist :)

Why is psychology important right now? What have psychologists done for me lately?

It's really true. When you understand this, it makes you realize how shallow and empty so much of economics really is.

Macro investing literature is what you should read if you want to understand the economy. It's less focused on high level concepts and more on specific data points and how they relate to and impact one another.

You know economics isn't just macroeconomics, right? "It assumes people are rational" is like saying physics isn't a science because "it assumes cows are spherical."

Only if physics entirely consisted of the study of cows, as economics consists entirely of the study of people.

Empirical economic studies exist and don't need to make rationality assumptions. It helps if you don't listen to Austrians or anyone from Chicago.

Shhhhh... You're spoiling the myopic STEM elitism.

I know a number of economists from chicago and they're very strong empiricists.

Yeah, but their opinions on hot dogs are terrible.

A lot of people confuse what's taught in econ 101 with what the majority of the field is working on. The vast majority of economists do not assume people are rational actors and with with empirical date day in and day out.

>it imagines people as rational actors, and we know they are not always

Maybe so, but almost all of the irrational actors that still have any savings know not to get fancy in the securities market.

More of a social science

It is as much a science as any other study of a complex system. Meaning, yes, it is a science.

Economics can be deeply mathematical once you consider the game theory aspect, analysis etc.

The problem with mathematical economics is that the models are incomplete, and people aren’t perfectly rational actors. Math got us into the financial crisis in 2008.

> The problem with mathematical economics is that the models are incomplete, and people aren’t perfectly rational actors.

I don't understand this criticism. All sciences are based on models that lie somewhere between incomplete and utterly wrong, but still these models are in fact useful and provide value. Take for instance physics, and how in some applications gravity is still modelled as a constant acceleration of 9.8m/s^2 pointing down. Although that model is very wrong it still works well enough to be useful.

The models are incomplete in chemistry, too, but that doesn’t make it “not a science”.

In general you must choose a model on some scale between “accurate but too complex to be useful” and “easy to use but too inaccurate”. In the middle, hopefully, lies some theory which is simple enough to use in analysis and accurate enough to have applications.

For example, you wouldn’t see a civil engineer design a bridge with quantum field theory. They would generally use a less accurate, incomplete model of materials physics. Something simple enough that they can parameterize and run simulations.

Science is there in order for us to understand the limitations of these theories. This is why you can still e.g. use Lewis diagrams and get work done. They didn’t become “not science” just because they are an incomplete model of how bonding works, but through scientific experiment we have an understanding of how useful the model is.

Yes, bond ratings were a big cause of 2008. Adverse selection/the market for lemons was a big part of that. Suppose the bond rating agency has a set of criteria to rate a bond AAA. You figure out how to structure your product to meet the letter of those criteria in one tranche, but the characteristics of the product's statistical distribution is very different than what the person who made the criteria was expecting. Or, you convince the bond rater into making some more statistical assumptions about the product that the product doesn't actually meet, and then you pass the AAA test with those assumptions in place. There is a blurry line between #2 and #3 which is basically just paying off the bond rater.

Ultimately modern structured products creation and sales is basically just like old-school used car sales. Put sawdust in the motor, roll back the odometer, and tell the customer that it was driven by a little old lady that only took it to church and to the supermarket. Caveat emptor.

Math got us into the financial crisis in 2008

That is a terrible misunderstanding of the 2008 financial crisis.

I thought using Gaussian copula for CDO pricing was often regarded as being an important factor in facilitating the crisis?

there's a charitable way to read that, which is that they did ample statistical modelling/risk analysis of CDS and "concluded" they were safe enough to bundle mortgage debt under. Then you could sort of "blame math" (or the abuse thereof) in that circumstance. I know CDS is only like 1/10 chapters of the whole crisis, however.

The whole "people as rational actors" isn't a major underpinning of economics anymore, or is being phased out.

This armchair analysis of economics is wrong. Only a small portion of it assumes every person is a rational actor.

Unfortunately, because otherwise the models wouldn’t work. Tell you more about the models than people.

My favorite economics quote: "the market can stay irrational longer than you can stay solvent."

Also known as: "you can lose a lot of money by being right at the wrong time."

It's doubly true when the market is as heavily manipulated as it is today. There's no point in trying to game or predict it at the scale of an individual investor, unless you enjoy the thrill of gambling.

I don't believe the second quote is equivalent to the first quote.

> There's no point in trying to game or predict [the market] at the scale of an individual investor, unless you enjoy the thrill of gambling.

I don't agree with that, either. You can expect the value of stocks in general to go up over time in proportion to the growth of the global economy, which has been broadly predictable since the industrial revolution.

You can also hedge risk; not all investments are about making money.

Finally, you can certainly outperform the market if you have expertise in a certain sector of the economy.

Your complete dismissal of all investing as "gambling" is flippant and incorrect.

Warren Buffet is wealthy for a reason.

There is a kernel of truth in what you said if it is restated as: amateur investors should not expect to outperform the market.

Certainly not all investing is gambling, but picking individual stocks and timing the market are pretty close to gambling.

Warren Buffet started and made much of his fortune when there were more inefficiencies in the market. It's not clear that the same method would work today.

With all of he data and speed that goes into trading, it's pretty unlikely that you have an informational edge unless you're able to pay for more data sources than everyone else and you have an army of humans looking for patterns for you. That is you need to spend a great deal of money getting that edge. Presumably that is somewhat what Renaissance is doing.

Even then you have to deal with the fact that insider trading is essentially instantaneous with modern communication and trading platforms.

I think you are not making enough of a distinction between short-term trading based on technical factors and long-term value investing, which is what Warren Buffet did/does.

This is obliquely addressed. The methodology of value investing is well known by now. The goal is to buy underpriced stocks.

If you want to play that game you have to compete against large firms that have buildings full of people looking into the fundamentals of the companies. Or you need some other informational advantage.

Otherwise you are almost certainly buying correctly-valued stocks. That's not value investing, but you can do something else that is useful, like buy an index.

I don't believe that the stock market is efficient in the way you are suggesting.

For one thing, there are lots of companies I can buy into that Warren Buffet can't, because he can't take a meaningful (to him) position, because he would end up owning the entire company. And even that may not be enough to be meaningful to him.

I suspect this phenomenon also exists for firms and institutions much smaller than Buffet. It may not be that they would own the whole company, but simply that they would own too much of it and/or move the price on their own.

For another thing, lots of investors are irrational. They follow fads. There are certainly opportunities for contrarians.

Value stocks have underperformed in the last 12 yrs, but these things tend to follow cycles, so I'm guessing they will have a comeback. Here is an article about that: https://www.wsj.com/articles/the-agony-of-hope-postponed-by-...

> you can do something else that is useful, like buy an index

That is precisely not useful in terms of efficient price discovery, though it may be "useful" to the individual investor who has better things to do with his or her time. That is one kind of behavior that causes inefficient markets that careful investors can then exploit.

> which is what Warren Buffet did/does.

It's what the vast majority of people and businesses do with their money. Only a small percentage are investing in risky trades. And the ones that do that have plenty of money to spare and are well aware of the risk models.

> It's what the vast majority of people and businesses do with their money.

The vast majority of people invest in founds that deals with short-term gambling. Heard of LTCM?

> The vast majority of people invest in founds that deals with short-term gambling

I really doubt that.

If only that were true. Just look at RobinHood, for starters.

Just look at a rare unicorn in Silicon Valley that immediately drew SEC scrutiny?

What does that have to do with the average investor?

I believe the investors were the ones to look at. The infamous /r/wallstreetbets in addition to self-deprecating jokes about themselves being basement dwellers essentially engage in outright gambling on shorter term swings and hunches to make and lose big - mostly the latter.

it's pretty unlikely that you have an informational edge unless you're able to pay for more data sources than everyone else and you have an army of humans looking for patterns for you

Not really. Exhibit A: Follow realDonaldTrump on Twitter. Look what happened to the SPY index starting at 13:26 EST on 8/1/2019.

[A] https://twitter.com/realDonaldTrump/status/11569794468779622...

SPY -> https://i.imgur.com/MDp7zHS.png

Even if it took you 10 minutes to decide to short the SPX/SPY on that information, a leveraged trade made plenty of money over the following days.

There is an abundance of free information available these days. To people who hone their market discernment the edge is arguably more accessible than ever.

Why do you suppose that people managing significantly larger sums of money than you have available are not also investing based on this information? If they were, your edge would rapidly drop to zero as all of the better connected and better funded investors buy up the over/under-valued assets.

In trading as an individual, you don't need to beat the big guys, you just need to hit your objectives (hedging/profit targets). If someone moved later than the big guns, but in the same direction, with reasonable risk assessment/management, then it can still be profitable.

If they moved against, and had reasonable risk management, it should minimize losses.

It assumes rationality not omniscience or complete understanding and the markets are a big place - not space big but still quite a lot even at the level of public news. Even then it would take time for the easy money arbitrage to stabilize.

I agree that "you can expect the value of stocks in general to go up over time in proportion to the growth of the global economy", but this does not contradict "There's no point in trying to game or predict [the market]". Parent is not saying to avoid the stock market. Parent is saying you should not try to outperform the market by making targeted stock picks or getting in and out of the market at targeted times.

I don't understand why you are saying that.

You're right, that sentiment was probably too cynical and defeatist. It just feels like one of those cases where the playing field isn't anywhere close to level, and even if playing the game is rational sometimes, you still reinforce the systemic imbalances which tilt the field by doing so. Oh, well.

> Warren Buffet is wealthy for a reason.

Is it because of luck? Not trying to be silly, but how would you truly know it isn't just luck? E.g. read Fooled by Randomness for more background.

Buffet has a methodology that makes sense. That is a better explanation of his success than positing that it was random luck.

In general, though, if you look at mutual funds and hedge funds, I suspect that a lot of the winners and losers can best be explained by random luck. So in that sense, I agree with you.

I haven't read Fooled by Randomness yet but it's on my bookshelf ;)

The article seems reasonably believable. It offers more than the typical fluffy clickbait title with no supporting details. This article has details that merit the title's claim.

Science communication for anything important to people (e.g. economics, climate, psychology, health) is generally terrible. On one side, you have people saying "looking at statues makes you atheist" or "this bubble is about to burst." On the other, you have "psychologists are garbage"/"climate change isn't real"/"economists can't predict recessions so they're idiots."

The solution is the same for all of them. Effort. When you see reporting you're interested, find the original paper and skim it. At least read the abstract. Turns out the people actually doing the work are usually pretty sensible. There's a lot people don't know, but with this "one simple trick!" you can learn what we're less uncertain about.

> Turns out the people actually doing the work are usually pretty sensible.

The replication crisis suggests otherwise; they’re often delusional (believing in things that aren’t there) or outright frauds (publishing results they know are false for personal gain).

Sometimes? Yes. Often? I don't think so. Usually? No absolutely not.

Go read Principles for Navigating Big Debt Crises by Ray Dalio. They (Bridgewater, biggest hedge fund in the world) look at data and economic history, and they’ve done quite well by it.

See also this video he did on How the Economic Machine Works: https://www.youtube.com/watch?v=PHe0bXAIuk0

Oh yeah, excellent high level summary. I had seen it mentioned, but had never watched it, thanks!

Aye, I've a friend who in recent months has moved most of their investments from the stock market to cash. Why? Because of the massive increase in people doing cocaine. I knows it's cliche about the correlation between that and an impending crash but still, seems extreme to actually put your life savings on it!

The market is also expensive by historic standards and you can make arguments that the expected return going forward is low or negative eg. https://www.gurufocus.com/stock-market-valuations.php

Yes but people have been (rightly) saying this for years. And you'd have been mad to get out of it back then. I'm a passive investor guy. I can't call it and will continue my drip feed.

The foreign cash repatriation was a one time deal and has kept this run going. We are also going to have to see more boomers continue to increase their withdrawals. I'm also worried about the long term effect of the "bonus depreciation" that was in the tax cuts.

You have to go meta! Don't just read the news, but try to figure out why they are telling you to buy or sell. ;-)

Everything I'm not personally an expert in (which I can't verify myself with my own understanding, other than by trust), I assume is somehow deception and largely ignore (until I'm smarter and more well informed). Taking anything from an article like this is only going to muddle up your understanding of the world (which you'll eventually have to work to disentangle).

>it's hard to tell what's valid anymore.

That's the plan as it turns out.

From the comments:

"Moving to dismiss the suit in a California federal court, S&P said that reasonable investors would know its assurances of independence were just marketing, and that its ratings should be treated as free speech, not as financial statements." https://qz.com/101722/sp-amazingly-says-no-one-should-believ...

I upvoted this because I thought it was an Onion-like satire; but no. No it is not.

> like a used-car salesman who tells you the last owner of your car was an old lady who only drove it on Sundays.

Wow, that's literally what the salesman said when I bought my first used car. And I believed him, because of the low miles.

Someone should sue to get banks to stop using S&P, using this suit as evidence. (Yeah, I know, establishing standing to sue would be problematic...)

Banks don't use it. They provide the ticker just for convenience to their customers/clients.

Well, all right, but aren't there clients who legally have to invest in instruments that have at least rating X?

Yes, those are big institutional investors, eg. pension funds.

It's not like there are only a handful of AAA investment options.

And those investors don't only depend on these rating agencies. (They have their own fund managers, they have different divisions for different type/risk of assets - for example some dude going after risky VC type investments, a trader doing daytrading with stocks and other more liquid things [forex, derivatives <this is where the ratings come in>, money markets].)

But they don't just blindly buy anything that has been rated AAA.

In that sense the fact that rating agencies inflate ratings just means these big funds have more options to put on some more risk.

Of course, investing always had and will have some gambling style part. Because yes, maybe some thing is doomed to fail, but ... if that's thing is very large [eg. all of housing, or all of mortgages] you'll have to either hedge that risk anyway (and/or basically short it), or go in long, set up saddle options, etc. And usually that what happens, and then eventually reality gets more complex and enough small unnoticed bad assumptions get built into the system that it starts to crumble.

Naturally, it's not a great thing, because it has real world consequences. Funds go bust, projects get stopped, orders get stalled/cancelled, people are let go, families are stressed, health becomes at risk, lives are lost.

Is there a better system? Well, so far not really. The problem is not that there are some sophisticated bets on new research & development, new real estate, new capacity expansion for some company, or even betting on people paying back loans OR getting a house, or even the securitization of this is not a problem. The problem is that US and a lot of other "modern societies" don't have sufficient support nets for when those bets fail and people lose their work.

One pretty solid indicator of recessions to the year or two is the inverted yield curve on short and long term yields. From the FRED: 10-Year Treasury Constant Maturity Minus 2-Year Treasury Constant Maturity (T10Y2Y) [1].

Once it dips and inverts, recession seems fairly consistent. Nothing is ever guaranteed but it is better reliability than most financial media, though the possible inverted yield curve is getting attention [2].

Machines and A.I. run it mostly now though, so game theory is now in their/algorithms hands. We are mere spectators in the speculative simulation. They are definitely watching for an inverted yield curve.

[1] https://fred.stlouisfed.org/graph/?g=lFt2

[2] https://www.bloomberg.com/news/articles/2019-08-05/yield-cur...

See also the 10-year Treasury minus 3-month Treasury, which seems to do even better at recession indication:


I have to say wow! I haven't seen better predictor!! Why do you think this is such a better predictor?

I read somewhere that this only seems to be an indicator for the United States.

For the rest of the world it has not been a predictor. Unfortunately I can’t remember where I saw the article in the past day or two.

German is already entering to recession so the rest eurozone will follow very soon. https://www.theguardian.com/world/2019/aug/07/german-industr...

Also Chinas economy is slowing down but the problem is that probably nobody knows how much.

There are a number of countries cutting interest rates to attempt to help their slowing economies.



Were German yields inverted 18 months ago?

The inverted US yield curve is supposed to predict a US recession.

It doesn’t say anything about the rest of the world.

I saw this also. I saw it as a post on The Economist's Instagram. I didn't read the full article.

If you're interested in more on the yield curve inversion, there are three recent (March [1], August [2], and October [3] 2018) SF Fed Reserve Economic Letters about it:

[1] https://www.frbsf.org/economic-research/publications/economi...

[2] https://www.frbsf.org/economic-research/publications/economi...

[3] https://www.frbsf.org/economic-research/publications/economi...

Is there a market opportunity for completely automatically generated security ratings? Individuals in most developed countries are now assigned a completely computer generated "credit score" (from payment history and applications for credit); is it much more difficult to algorithmically assign an analogous score for a bond or similar instrument?

EDIT: Or is the problem a misalignment of incentives? It appears that investment rating providers are paid by the managers/sellers of the securities rather than the prospective buyer of the securities. This may create an incentive to attract more business by inflating ratings. If prospective investors paid for the ratings, perhaps there would be a different incentive alignment (and also possible opportunities for tragedy of the commons).

I was a former ABS banker and I personally think there is an opportunity to automate the structured finance ratings process.

Here is how it works today. An originator finds people to lend to, aggregates them, works with a bank to structure them into a security that gets rated and then institutional investors buy the securities. Rating agencies get paid to apply their ratings criteria which they publish, allowing you to reverse engineer the model.

The opportunity, in my opinion, is a point of sale system where you hand iPads out to car dealerships, clinics whatever. Someone wants to make the big purchase, puts their social in and gets funded by the institutional investors on the spot. An institutional investor at the moment won’t get a say on funding, the platform will. They will simply set their high level criteria and the system will continue funding to get to some average that fits it.

For example, I could be an investor that says I want $10mm of subprime auto loans per month with average FICO if 615 and min/max loan sizes of XYZ. That gets entered into the system and then the dealerships continue handing iPads at the point of sale. The cash flow of the loans can move through the waterfall and ratings can be real-time in the flow as opposed to the security.

Anyway not sure if this makes sense as it is nuanced and I am being high level.

The problem is that this doesn't track correlations between people. The implication is that each user has an independent risk, but that's not always true. In particular it was the problem with CDOs during the last crisis: people assumed that one person's default would not cause another's, and what seemed like a collection of moderate-risk loans was actually very high risk in aggregate.

If you're aware of that fact then you know what you're getting and can deal it. But it's the tacit assumptions, magnified by aggregation and automation, that caused a disaster.

Real time cash flow seems like overkill,props if you can do it though. You see some lenders in the merchant cash advance market doing similar POS flow analysis. Lots of structured products have liquidity facilities to bridge short term issues so credit quality throughout the cycle tends to matter more than ST flow imo.

I think the big issue with that is those institutions don't want to be acting as loan servicers. Someone needs to do all the work of processing payments, working to define alternate payment plans in some cases and doing foreclosures/reposessions when someone defaults. Who does that in your model?

1. When you say 'credit score', I presume you mean the score assigned by the credit bureau. This isn't an objective measure, and sophisticated lenders develop their own scores (using raw+summary data from the bureau and other sources).

2. Analysing the ability for a large/complex company to pay back a bond is pretty complicated, as it depends on understanding the operations of the company, and the riskiness of the cashflows generated by those operations.

3. Your point about misalignment of incentives is correct, and mentioned in the article.

The problem with that idea is that as soon as you define objective criteria, people will find a way to game those objective criteria.

how is this different from the current rating system the article is about?

The answer to your question is almost certainly no. This is because credit ratings are not based on payment history, or anything as simple as that. Instead, credit analysts have to understand how what can be complicated legal structures work.

Can legal agreements be expressed as an algorithm?

When logically consistent, but the written contract is not always the final word. Example: lack of consideration (https://www.nolo.com/legal-encyclopedia/consideration-every-...)

If they could in all cases then we wouldn't need courts.

Not to replace courts but to understand legal agreements better. If you could express it as an algorithm, perhaps, you could rewrite in simpler english or answer questions about it?

You'd still run into the halting problem. And you'd have lawyers wanting to write legal agreements that run into that, so that nobody can determine what they really mean, so that nobody can prove what a scam they are.

Options contracts are exactly this.

The success of such would require extreme precision in modeling assumptions. For example, risk ratings on CDOs with mortgages assumed independence -- but that doesn't hold in reality. At least early[0], on this was recognized as a contributing factor to the misalignment in risk rating, and could have been completely automated.

[0] https://www.wired.com/2009/02/wp-quant/

It takes human cognition to understand the degree of independence. A machine could not have figured out the broader macroeconomic forces at play that led to mass defaults.


Frankly in the financial world there seems to be a market for everything, useful or not.

"In the City, they sell and buy. And nobody ever asks them why. But since it contents them to buy and sell, God forgive them, they might as well."

Are you sure? I've never heard of credit score before moving to the US. Or maybe it's more invisible where I'm from

There are at least three debt markets that will cause problems.

1. Student Debt - It is non-renounceable. Bankruptcy does not clear it.

2. Oil and gas companies - the entire "fracking revolution " has been funded by loses from bondholders.

3. All Private Equity debt - the basic business model is broken.

You forgot car loans. A few years ago my wife was offered an 84 month loan when she was unemployed. Very few people keep a car for 84 months. I'm sure there will be a lot of people underwater on those loans pretty soon.

Oh... given the people inside my little bubble I'm surprised to hear people don't. If the economy tightened up, presumably people would compensate by keeping the car longer though?

And service the debt with what job?

are you not underwater immediately on any car loan? sure it's worse on 84 months, but the old saying about "once you drive it off the lot" would apply to any loan would it not?

Most normal car loans are for four or five years and leave you about even three years in so If you trade it in you don’t owe anything.

This is only true in the short run for new vehicles. A well-maintained vehicle will hold a significant amount of value after 10+ years. And if you are fortunate or savvy enough to buy a car that will obtain “collector” status you may even make a nice profit. One extreme example is the 86’-91 Volkswagen Vanagon Syncro, which can be sold for up to $90k today.

A more common example is the first generation Toyota Tacoma (00’-04’) that is currently going up in price, I’ve seen closing prices at $15k in the last year. Small trucks are now extinct and this particular model is proven to be absurdly reliable, but who would have predicted that 10 years ago when these were selling for $3k-$5k?

Your examples are trendy vehicles that have hordes of fools lining up to pay multiple grand for examples that can't even move under their own power. Nobody in their right mind would say that classic VW vans or any Toyota pickup is indicative of market patterns in general. They are what the "cool kids" drive and pricing reflects that.

Diesel trucks used to be grossly overpriced too but now that most of the older stuff has aged out and the "new enough to still be kinda nice" market segment is full of emissions era diesels the crazy pricing has mostly gone away.

Wow a little harsh, don’t you think? Maybe I should have used the Toyota Corolla instead? These weren’t trendy vehicles when they were new, that’s my point. Perhaps you missed the part of my comment where I prefaced with “If your fortunate...”? Because obviously this was an off-topic side comment countering GPs generalizing that all cars necessarily lose value, not a strong claim about the market as a whole.

I can't speak to the VW but the Tacoma was absolutely trendy when new. From 2000 or so to present it has been the official pickup of "I don't 'need' a pickup but I make good money, I like nice things and I want a pickup" (I'm not saying there's anything wrong with that reasoning). They've always (even back to the 80s and 90s) been more expensive than the alternatives when new so only people who are dead set on them tend to get them.

They're comparable to the Jeep JK and the WRX STI or a performance trim Mustang/Camaro but for different demographics. Anyone could tell you that they would hold value better than average when new.

Losing less value than average is not all that remarkable. Gaining or failing to lose value is exceptional and subject to the whims of consumer culture (see my tangent about diesel pickups). Jeep Wranglers used to be like that but as the 4dr JKs hit the used market it calmed down a lot. Old full size Broncos are probably about to stop losing value if the rumors of a new fullsize are to be believed.

Also I toned down the language in the original a little.

Are you sure you're not mistaking it with the later post-2004 models? The early model MSRP'd at <$20,000 ($26k today infl. adj.) and was a small pickup, nothing like the full-size $45k beast that is offered today. It would be odd to compare it with the $35k WRX STI.

Anecdotally, I purchased a used Tacoma in 2011 for a few thousand dollars as a family workhorse vehicle. I sold it for nearly double five years later with only making regular oil changes. This really changed my impression of the used car market and have since started a side hobby buying and restoring "almost-classic" vehicles.

I'm not comparing it in terms of cost, I'm comparing it in terms of how buyers think about it. People buy a WRX STI not because they don't know what they want and it seems reasonable. People don't buy a WRX STI because they want a sedan, do a bunch of number crunching and decide it's the best fit for their needs. People buy a WRX STI because they're in the market for a sedan and they want a WRX STI. The same is true for the Tacoma and a whole host of other vehicles. People buy a Tacoma because they specifically want a Tacoma and they pay out the nose for it (especially if buying used).

These are outliers though, and in macroeconomics will have near zero impact.

Yes I’m aware, didn’t intend to imply otherwise

It's the difference between book value and economic value

Even 84 months ago around a third of those trading in a car for a new one were underwater on the trade-in.

Auto-loans are the only ones that I've ever heard of that allow you to take the balance of one note and just move it to a new note. Maybe credit card balance transfers, but those are just moving debt from one holder to another. Car loans are adding the balance of the existing note to the new loan.

Isn't the average 10 years?

The average new car loan is 5 years 9 months. The average used car loan is 5 years 5 months.

> Oil and gas companies - the entire "fracking revolution " has been funded by loses from bondholders.

That's no longer a serious problem (and is in fact an opportunity for the majors that have taken over). That's several years in the past as a large risk. At the scale of the US economy and its wealth, the remaining debt implosion risk in the fracking (Permian etc) segment is trivial.

The fracking buildout is over and consolidation has already largely occurred. There are only a few relevant small players left to be acquired by the majors. Companies like Exxon, Chevron, ConocoPhillips, Devon, Pioneer, Apache, Concho and Occidental own everything. And a few of those are guaranteed future acquisitions for the big guys, including Devon and Apache. The majors have no real capital problems when it comes to affording to deal with swings in the price of oil, unlike the early years of the fracking boom when dozens of smaller firms still mattered and were highly leveraged. And at this point we know where most of the oil is at in the prime fracking zones, the little wildcatters served their purpose.

Please tell me where you can read more about the idea that "the entire "fracking revolution " has been funded by loses from bondholders"

To be fair there have been plenty of losses from stockholders as well.

1. Economically speaking, this is actually a really good thing in terms of stability. We would be much more concerned if these borrowers could default. Instead, they have to work, which is good for our economy and good for this specific debt market's health as a whole.

No it’s not. The need for work doesn’t offset that economic calamity that happens with a liquidity crisis and the subsequent devaluation of the dollar. That means people need to work and there’s no money available to pay them. You get a run on banks with more debt than cash available. Everyone is frozen.

Are you saying that student debt being non-renounceable is bad if and only if we have a liquidity crisis? Because, that's the way your comment reads, to me at least. For the record, I am not endorsing this type of structure for all forms of debt. I am simply bringing to light a more positive view on the supposed "student loan crisis". If so, let's look at some numbers to paint a broader picture: the US mortgage market is 10x the size of the student loan market with average monthly payments in the $1000-1600 range, whereas the national average student loan payment is less than $500. If there were to be a liquidity crisis, the worst we would see out of the student loan market is a larger fraction of borrowers struggling to come up a few hundred dollars per month throughout the recessionary cycle. I just don't think this market is large enough to have the kind of effect your are describing in your comment. I think your comment makes sense for debt as a whole, but I don't think it scales well with the market it's targeted towards.

This might be stupid - but why are these credit ratings agencies allowed to exist in a comparatively free market? Surely a function like the one they provide is better handled by a Not-For-Profit governmental body?

Without this - or incredibly tightly policed regulation of the existing private agencies, I don't see how an outcome like the one described here isn't mathematically guaranteed?

Bond rating is literally a speculation. Government body would need deterministic definitive rules to assign bond rating which would immediately be gamed. The idea of having private firm do speculation instead is that if they are not good at it then people will stop using them and strongest would eventually survive. Unfortunately, they are well enough "protected" to go away.

What we need is credit rating agency rating agencies.

Then, of course, ...

The $ Combinator

Agreed, profit motive in the rating agencies was to blame during the 2008 financial crisis buildup:

>The Financial Crisis Inquiry Commission estimates that by April 2010, of all mortgage-backed securities Moody's had rated triple-A in 2006, 73% were downgraded to junk

>many of their ratings turned out to be catastrophically misleading, the large rating agencies enjoyed their most profitable years ever during the past decade.

I think we should have new state run ratings agency, one that competed for ratings at market rate. This would force the private labels to at least give out more plausible ratings.

[1] http://www.gpo.gov/fdsys/pkg/GPO-FCIC/pdf/GPO-FCIC.pdf [2] https://www.sec.gov/news/speech/2009/spch020609klc.htm

> why are these credit ratings agencies allowed to exist...?

Are you going to ban people from giving opinions as to whether various investments are good or not? As well as being anti free speech it would make life harder for investors. However I guess you could have a government controlled agency in parallel. Or regulate the agencies that their ratings have to be reasonable to get a license and ban/fine them if they are giving AAA ratings to junk.

> Are you going to ban people from giving opinions as to whether various investments are good or not?

We already do basically do that for legal and medical advice.

And it is regulated in the financial space as well.

There are plenty of industries where companies don't exist in a particularly free market, and have to operate according to extremely strict regulation. Thats all I meant :)

I guess the standard argument is that a governmental credit rating body would slow things down. If fintech startups needed some new feature from the credit rating agency, they might not be able to get it in a reasonable amount of time. Is that slowdown worth the tradeoff of occasional crises like this? I guess society has made its choice.

> Sometimes one firm called a security junk and another gave a triple-A rating deeming it supersafe.

Doesn't this suggest that the ratings are providing close to zero signal?

Insufficient information to judge that to be the case; they rate millions of bonds and, statistically, they’ll almost certainly have every type of disagreement occasionally. The difference between AAA and junk isn’t 99 and 3 on a 100 point scale; it is somewhere in the neighborhood of 99.9 and 96.0 on the 100 point scale “Likelihood to not default within 1 year.”

You’d need vastly more data points to firmly believe the conclusion “Their ratings are indistinguishable from being randomly generated.”

There are people on Wall Street who can appreciate this math. A statement which is true and necessary but may not be kind: Wall Street does not allocate their talents towards producing journalism.

It depends on each agency's historical performance (maybe only one is bad) and how often this discrepancy happens. Ratings are probabilities to be evaluated statistically.

As you ask more rating agencies the rating becomes more accurate. If you already know the correct rating and then intentionally pick a rating agency that would give a different score then yes it would provide zero signal.

There’s nothing else to invest in though.

If investment grade bonds are all crowded overvalued trades then you have to go further out on the risk curve.

If the market is slow to do that then the rating agency will just start inching ratings up and lowering criteria

Now there's an understatement. It's a completely fraudulent industry.

EDIT: It's also one that's ripe for a good and proper YC-unicorn style disruption. Hit me up if interested.

I'm struggling to envision how a tech disruption could work in this market. The essential problem seems to be an incentive system that's misaligned with investor incentives and overall economic health.

How could a single company or group of companies alter a broken incentive system? It seems the two most salient options are (1) consolidation of competitors to reduce the race-to-the-bottom competition or (2) stricter regulation to prevent the kind of ratings shopping that debt issuers currently engage in.

While I can see how a tech disruptor could potentially put all the other ratings agencies out of business and achieve (1), this seems like a tall order. And my uneducated gut-reaction to that scenario is "decreased competition bad," although I'm open to being proved wrong on that, as this does seem to be a case where competition has caused the problem (from the article: "One author, Colorado State University Finance Professor Sean Flynn, says “competition among credit-rating firms has, if anything, reduced the quality of credit ratings.”")

How do you know that?

..weren't you there for the crash?


The article even spells it out - they haven't changed their business model since. Bank needs a rating on a asset, but their incentive is to get a "better" rating, not a more honest one. There are multiple agencies, so banks shop around for the most favorable one. So, as soon as one agency loosens their ratings, they all follow suit. They sell good ratings. That's the industry.

Quote after quote:

The Financial Crisis Inquiry Commission (FCIC)[39] set up by the US Congress and President to investigate the causes of the crisis, and publisher of the Financial Crisis Inquiry Report (FCIR), concluded that the "failures" of the Big Three rating agencies were "essential cogs in the wheel of financial destruction" and "key enablers of the financial meltdown"

U.S. Securities and Exchange Commission Commissioner Kathleen Casey complained the ratings of the large rating agencies were "catastrophically misleading", yet the agencies "enjoyed their most profitable years ever during the past decade" while doing so.[41] The Economist magazine opined that "it is beyond argument that ratings agencies did a horrendous job evaluating mortgage-tied securities before the financial crisis hit."[42]

According to columnist Floyd Norris at least one rating agency—S&P—responded to the credit crisis by first tightening up its standards and sacrificing market share to restore its reputation,[83] after which it loosened standards again "to get more business",[84] tripling its market share in the first half of 2013.[85] This is because, according to Norris, for rating franchises to be worth anything, they must seem to be credible to investors. But once they overcome that minimal hurdle, they will get more business if they are less critical than their competitors.[84]

and on and on and on.

I still think ratings agencies, if their ratings are to be required, should have money where their mouth is.

There are a number of ways this could work; one is they issue a contract redeemable for the difference between their predicted performance of a given company and the actual performance.

If they're as good at this as they think, they get another revenue stream. If not, the victims of their conflicts of interest have some insurance.

>Bank needs a rating on a asset, but their incentive is to get a "better" rating, not a more honest one. There are multiple agencies, so banks shop around for the most favorable one. So, as soon as one agency loosens their ratings, they all follow suit. They sell good ratings. That's the industry.

Memorable scene from The Big Short (2015) - "FrontPoint Partners confronts S&P"


Its the same model as People Love Us on Yelp, Who's Who in X, and your local magazine's annual local business awards

I see. How do you choose bonds for your investment portfolio?

because all problems anywhere can be solved by tech from a start up out of Silicon Valley. Where else are people making the world a better place with their disruption? </snark>

Is this a hit piece on smaller ratings agencies?

For example, the only charts on the page show how smaller agencies give higher grades on average. What does this have to do with risky asset vehicles exploding in popularity? Not much.

There are many obvious explanations to this that the article doesn't even mention. Like how a slightly lower rating from a bigger agency may still carry more weight, skewing ratings higher the smaller the agency.

The article mentions several times that additional ratings agency competition has made things worse. And that doesn't make any sense, investors now have the ability to choose who they believe.

The bond inflation part of the article is believable, but the focus on comparing agencies to eachother is suspect to say the least

Is it time to have a federal agency assign debt ratings.

After all we don't let the pharmaceutical companies determine if a drug is safe.

The feds may well outsource ratings to private companies but those companies are no longer beholden to the issuer of the debt.

Yeah, that’s what we need. More government to guarantee that bonds are good when they’re actually shit. The Federal Reserve already does a fine job of that. After all, US treasuries are AAA, right?

The Coming Bond Market Collapse: How to Survive the Demise of the U.S. Debt Market - Michael G. Pento

This is a good read if you'd like to have an understanding on what's coming up next.

That book is 6 years old.

"Economists have predicted 9 of the last 5 recessions."

Like politicians, smart economists wait to make predictions—growth or recession—until two quarters later.

As a group they miss acute macro moves, altogether.

Yeah, that's what I looked for right away. I mean, I'd read it if someone could tell me if explains the structure of (international) bond markets so at least I can come to my own conclusions about the 'imminent collapse.' Authors frequently bow to editors/publishers as far as the title goes. So maybe Pento didn't want to call it that.

But then the blurb talks about how he "accurately predicted the housing bubble" so then I think, nah, Pento also wants us to buy into his new prediction.

Though the folks on Goodreads that read it are sort of 50/50: https://www.goodreads.com/book/show/16719321-the-coming-bond...

This guy liked the parts where the book introduces you to specific macro concepts/schools: https://www.youtube.com/watch?v=uhSJ429r9mk But the comments are pretty negative.

So, was it accurate?

Don't keep fiat?

These ratings are not cause but the side effect of how much of a crisis this financial system is already in.

What about the incompetent companies giving these ratings?

For those that believe rating agencies are garbage: what bonds do you keep in your portfolio?

Tricky problem to solve. Maybe we don’t need ratings at all. Investors should simply perform their own DD on any deal as they naturally would. We can still rank companies on factors like leverage and coverage ratios for comparison purposes.

The trouble is when they're managing money for other people who done have a say - pension funds or whatever - and the government wants to have some way to regulate them. Because not restricting then from "dangerous" things would bad, whether or not it actually helps. (And with the way things went bad when the regulation stopped working, maybe it even does help?)

I don’t think it’s at all tricky to solve: Don’t believe ratings from people who are not investing their own money.

E.g., VCs in later rounds make sure that VCs from earlier rounds put in pro rata, because investing actions speak louder than words.

Until the misaligned incentives of the rating agencies get fixed, the ratings are really not worth the paper they’re printed on.

Investors don't have the manpower to do their DD on every bond issue they buy. You need to remove the ability of bond issuers to shop for credit agencies

Who is the buyer of these questionably-rated bonds? Passive bond funds? Pension plans?

Pretty much everyone who has bonds relies on credit rating. In particular on the "investment grade" rating.

How do you buy bonds?

Well my (shallow) understanding is that some entities are required to buy bonds of certain rating because of regulatory reasons or because that's what they promised investors. Other entities may not have such requirements but do rely on the rating because they don't have the resources to check the creditworthiness. And yet other entities may disregard the rating entirely and solely put their faith in their own analysis.

If I bought bonds myself I certainly wouldn't trust the rating. I'd only use it to serve as an indicator of how likely I can find a "greater fool"

So you have zero bonds in your portfolio? Directly or through funds (mutual/ETF).

We should go back to free banking. The current model privatizes profits but shares losses on the public.

There is no regulation that will fix the current system it is broken in its design.

I hope there will new banking through crypto currencies which work also for the environment.

If this was a app/provider outage and we would do a root cause analysis we would determine that monetary centralization is the root cause issue.

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