There is a population of bond investments, the risk to the principle in those investments is scored by a rating agency on a scale from D to AAA [1]. The market prices bonds using a combination of risk (as reported by a rating agency) and desired return. (Return is the independent variable). Economic theory says that the quantity of a good demanded influences the quantity supplied such that prices rise until there are no more buyers who will pay more and no more sellers who will offer for less. This relationship between risk and return manifests itself as a spectrum of bond offerings from those with low risk (AAA) and low return (< 2%) to those with high risk (D, aka 'junk bonds') and a high return (> 9%). [2]
It was with this understanding that I used the term 'mathematically impossible' when I was thinking 'the chances that there more AAA bonds in the population of all bond offerings than all the sub-AAA rated bonds put together, is astronomically slim.' For example, California's general obligation bonds are only rated at "A+" (up from BBB but still far from AAA). [3]
It could be legitimate, but were that the case the return on non-AAA bonds would be news because that would be the only way people would buy them. Since I'm not seeing offers for C and D grade bonds with 25 and 30% rates of return (and for some reason those folks seek me out and cold call me) I believe the simpler explanation which is that some portion of the bonds that are rated AAA don't deserve that rating (i.e. they are riskier than they purport to be).
And that, combined with some of the structural ways in which capital is managed in the world, makes for a much more explosive combination than we might otherwise be expecting.
[2] "Investors have been snapping up the new non-investment-grade bonds, having grown frustrated with stocks and with the meager yields on safer government and high-grade corporate bonds." http://online.wsj.com/article/SB1000142405274870396000457542...
But the point of these AAA ratings is that they are the 'top slice' of a pool of lower rated debt.
Suppose a typical student is has around $50 in their wallet at any one time : Demanding $50 from a student is pretty risky, and so is demanding $25. But if I have a large enough room full of students (say 100), demanding $2500 from the room (which on average holds $5000) is much less risky than requiring $25 from each person.
That's how AAA securities can be built from bad credits : Not everyone goes bad at the same time.
So the argument should not be about how crazy the idea of bad credits allowing the creation of good credits. The argument is about correlation coefficients.
Moodys / S&P / Fitch got the correlation coefficients between subprime borrowers completely wrong, because they believed that house prices could not all simultaneously decline in the US. And the investment banks had no incentive to explain the errors of their ways to them - and people who weren't "On-Side" at the rating agencies were relegated to lower-growth areas. And the regulators had no clue.
Isn't the difference between the AAA held by Berkshire Hathaway and the AAA assigned to a CDO tranche that very simple erroneous assumptions can lead you to assign low risks to large numbers of credit events that are subtly but decisively correlated? Finding uncorrelated investments in large groups of standardized assets is actually as much a tricky social science project as it is a green-eyeshades math problem, right?
When you AAA a product built out of supposedly uncorrelated risks that turns out to be correlated, you're fucked.
So, to extend your analogy: suppose you designed instruments backed by $5 debts from college students. And suppose as time goes on, Ivy League students used it less and less, while at UMich-Flint the program spread like wildfire. At some point, without even changing the explicit structure of your instrument, basic market forces might up converging on highly correlated (and very risky) buckets of risk, mispriced at AAA (or whatever).
And all the while, every incentive is set up to get people to throw away unfavorable results and cherry pick the most lucrative interpretations.
My point (you are by this point I am sure exasperated with me) is that ratings agencies and product designers are trying to build models to assign risks to quickly moving targets, by taking a spot measurement of the current correlation coefficients and extrapolating them.
Whereas on the other hand the credit history and business model backing BRK is (relatively) straightforward.
Your comment makes total sense [1] : I started looking at these collateralized debt obligations (i.e. CDOs) back in 2002. That was around the time of the first 'crash' in these structures (CBOs : structures backed by High Yield Bonds).
The basic error with CBOs is that the rating agencies allowed the structures additional diversity 'points' for investing in different sectors (a decent idea), but then segmented the market so that many, many different telecom-related businesses got put in different sectors. The telecoms bubble then proceeded to wipe out about half the contents of each CBO. Why didn't anyone point out the problem? Because the investment banks, having been given the published specification of how the Rating Agencies would model any hypothetical structure, went about optimizing the portfolios of bonds to maximize the 'ratings arbitrage' available.
Your point about migration of the underlying risks is spot-on. The rating agencies looked at the historical performance of each of the classes of risk. For CBOs, once people saw how the rating agencies would give them points for particular sorts of High Yield bonds, suddenly telecoms (& fibre, & cable, & satellite, & etc..) companies found it very easy to raise what were known in the market as 'CBO bonds' : bonds that no rational investor would want, but would be very appealing for a structure to buy (since it would help its ratios).
Similarly, once there were evening classes in how to improve your FICO score, the whole history of sub-prime borrower repayment statistics became irrelevant. The manipulation of the fundamental inputs to the models by 'good hardworking Americans' was rampant... But the Rating Agencies were being paid well to continue to rate structures (at a crazy pace), and the Investment Banks were in no hurry to point out that the models should be harsher.
Part of the whole problem, though, stems from banking & insurance regulations that mean that its very cheap (from an equity capital point of view) to leverage up AAA paper. That's what drove everyone to demand AAA paper in the first place. And the AAA designations is/was handed out by rating agencies that now claim it was 'free speech' and they're not liable for anything.
As for the moving target aspect : Investment Banks are continually trying to innovate, since that's where it's less competitive, and the margins haven't been competed away. They would ask Rating Agencies to look at new products all the time. If all the Ratings Agencies were too conservative (or cautious), then the product wouldn't work, and would be abandoned. However, if one of them could be persuaded to come up with an exploitable methodology, then they would get all the business...
And before anyone says : Ahh, Wall Street is just about the exploitation of loopholes, think about examples from hacker-space : SEO comes to mind...
[1] except for the example of BRK : That's a bit of a special business. Reinsurance is a tricky thing, and it's possible to look very smart until you discover you're an idiot. AXA looked pretty smart, until... Better examples would be AAA industrial businesses, or a hard-asset business, for instance.
There is a population of bond investments, the risk to the principle in those investments is scored by a rating agency on a scale from D to AAA [1]. The market prices bonds using a combination of risk (as reported by a rating agency) and desired return. (Return is the independent variable). Economic theory says that the quantity of a good demanded influences the quantity supplied such that prices rise until there are no more buyers who will pay more and no more sellers who will offer for less. This relationship between risk and return manifests itself as a spectrum of bond offerings from those with low risk (AAA) and low return (< 2%) to those with high risk (D, aka 'junk bonds') and a high return (> 9%). [2]
It was with this understanding that I used the term 'mathematically impossible' when I was thinking 'the chances that there more AAA bonds in the population of all bond offerings than all the sub-AAA rated bonds put together, is astronomically slim.' For example, California's general obligation bonds are only rated at "A+" (up from BBB but still far from AAA). [3]
It could be legitimate, but were that the case the return on non-AAA bonds would be news because that would be the only way people would buy them. Since I'm not seeing offers for C and D grade bonds with 25 and 30% rates of return (and for some reason those folks seek me out and cold call me) I believe the simpler explanation which is that some portion of the bonds that are rated AAA don't deserve that rating (i.e. they are riskier than they purport to be).
And that, combined with some of the structural ways in which capital is managed in the world, makes for a much more explosive combination than we might otherwise be expecting.
[1] http://www.investopedia.com/articles/03/102203.asp#axzz1SD85...
[2] "Investors have been snapping up the new non-investment-grade bonds, having grown frustrated with stocks and with the meager yields on safer government and high-grade corporate bonds." http://online.wsj.com/article/SB1000142405274870396000457542...
[3] http://www.treasurer.ca.gov/ratings/history.asp