A nice picture on how badly the mortgage crisis went (pinched out of an IMF publication). This graph doesn't include Fannie, Freddie, or Ginnie Mae securities (which the government backs). Instead it is of mortgage related securities from Wall Street and banks. These securities split the monthly mortgage cash flows into many separate bonds, each with their own priority of payment. The bond that is first in line to be paid each month from borrower payments is the safest and is rated 'AAA'. The rating agency will ask for riskier mortgages to have relatively smaller 'AAA' bonds so that there is certain to be enough mortgage payments to pay back the entire 'AAA' .
Rating agencies regularly review bonds, and can move their rating up or down based on risk. The horizontal axis shows S&P's rating of what was originally a 'AAA' rating as of 7/2010. If the bond has defaulted or default is imminent then it is categorized as 'CCC and below' ('D'=default).
So if we look at the 'CCC and below' columns of the graph, we basically see the default rate for what were considered the very safest mortgage related securities issued prior to the housing bust (2005-2007). Yet around 90% of the 'AAA' based on prime and Alt-A mortgages are defaulting. And around 60% of 'AAA' on subprime mortgages are defaulting.
How good is 'AAA' supposed to be? The 5-year default rate on corporate bonds rated 'AAA' averages well below 1%. 'AAA' should often withstand a Depression. The debt issued by the US, Canada, and most of western Europe is typically 'AAA'. And remember that many of those governments borrow money in their own currency and can create more currency to buy back their bonds in an emergency.
A 90% default rate on 'AAA' bonds for prime and Alt-A mortgages is phenomenal. Even the biggest bears wouldn't have predicted anything close to that bad in 2007. Of course, no one was predicting house prices in CA, NV, AZ, and Florida (high concentration states) would fall 50% in 2 years either. Maybe 30% over 4 years, but not 50% in 2 years! The rating agencies that determined 'AAA' certainly weren't considering that kind of a housing recession. And since rating agencies were paid by the Wall St. dealers and lenders who created the securities, in a way they were paid not to consider it.
The rating of 'AAA' caused many otherwise bright people to suspend critical thinking. Often I heard, "Don't worry, it's 'AAA'." A 'AAA' mortgage bond typically had a face value of around $100 million. For that kind of money, investors should do their own due diligence rather than relying on a rating agency (or anyone else) to evaluate risk.
Recent memories of what 'AAA' meant for mortgages is now haunting investors that hold US municipal bonds and peripheral Europe sovereign bonds that are rated 'AAA'. Does that mean massive defaults for them too?
I'm certainly not a muni expert, but there are two general kinds; some are general government obligations, but many are tied directly to paying for and being paid by particular projects (buildings, sewers, developments, etc.). So it takes research specific to each bond to understand the risk. As with mortgage bonds, I wouldn't outsource the research work.
On peripheral Europe sovereign risk, there is definitely systemic risk. The debt of some countries will have to be restructured and will technically default. The trick is to figure out what the cash flow will be after restructuring. And that relies as much on politics as finance. Ugh.