If you understand MBS, then this possibility doesn't seem ludicrous at all
Sometimes a potential headline is so sensational that it becomes almost impossible to resist writing an accompanying article. Yesterday, we saw a perfect example of this when Bloomberg published a story titled: "Subprime Mortgage Bonds Getting AAA Rating S&P Denies to U.S. Treasuries."
This headline is great for a couple reasons. First, you've got S&P's controversial downgrade decision in there. Then, you paired it with much-hated subprime mortgage bonds -- the securities often blamed for creating the financial crisis. Better yet: you've managed to imply that S&P has the audacity to say that those potentially toxic bonds are safer than U.S. debt! As great as this headline is, the point its accompanying article makes is worthless.
Those who aren't familiar with how mortgage-backed securities work might find this seriously disturbing: the rating agency Standard and Poor's recently rated a new subprime mortgage-backed security deal AAA, the same pristine grade that it recently denied U.S. sovereign debt. But those who understand mortgage-backed securities (MBS) will shrug and say, "So what?"
How MBS Works
In general, people who don't understand MBS probably find it totally absurd that bonds created from subprime loans could ever be awarded a AAA-rating. After all, aren't these potentially dangerous loans that will likely sustain lots of losses? Yes, they are. But that doesn't mean all of the subsequent mortgage-backed bonds that could be dreamed up and structured will be equally dangerous.
It's hard to find a perfect analogy to explain MBS, but let's try by thinking about pulpy orange juice. If it's all shaken up, then the pulp with be throughout the juice. But if it's left undisturbed for some time, then that pulp will settle at the bottom. In fact, juice makers have methods to create virtually pulp-free versions of the juice. Those who hate pulp can buy this variety, but those who love pulp can buy a much pulpier version that the juice makers create with the left over pulp and juice. Imagine that pulp is risk.
An investor comes along and wants to buy a subprime MBS without much risk. Like the juice maker does with pulp, a bank can structure an MBS where it minimizes the risk for some bonds within that deal, while other bonds are much riskier. So that investor can buy one of the "senior" pieces of the security without taking on much risk -- just like you could buy orange juice without pulp.
Then went so horribly wrong during the housing bubble? Everybody underestimated how much pulp there was in the juice -- or how much risk there was in the subprime loans. Imagine that you thought that the volume of some orange juice was only 30% pulp, but it was really 40% pulp. If you try to drink more than 60% of that juice, then you'll hit some unanticipated pulp. In a similar way, investors suddenly began facing losses that they hadn't anticipated, because the loans were riskier than they thought.
Imagining a AAA-Rated MBS
I am not familiar with the particular mortgage-backed security that the Bloomberg article refers to. But it's easily the case that a subprime MBS could be created with AAA-rated bonds. Imagine that, even in the worst imaginable scenario, the loans it is created from would incur 50% losses. When you think about mortgages, such losses would be very severe.