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AAA ratings: a 'grim' fairy tale

By Addison Wiggin - posted Tuesday, 7 September 2010


How the ratings agencies have managed to emerge from the credit crisis unscathed and unregulated is a mystery ... and a sham.

"Nothing is ever clear or certain in public," we wrote in The New Empire of Debt. "Every error is someone else's fault. That is why so many men prefer it. The public world is so surrounded in fog that he thinks he sees half-naked nymphs behind every tree and $100 bills under every cushion."

If Wall Street is a foggy valley of shadows where wise bankers pick the pockets of the wandering masses, then rating agencies act as the surrounding hilltops. No - not the pillars of transparency and relief from the villains below. Rather, they're the unscaleable, daunting cliffs that trap and thicken the fog. (This is the case almost literally, in fact. Moody's, Standard and Poor's and Fitch Ratings' major offices surround the lowest tip of Manhattan eerily ... Moody's to the west, S&P at east and Fitch at the southernmost point of the island.)

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While it is the duty of ratings agencies to assess investment risk and provide a clear playing field for investors of every kind, we all know that they have done just the opposite. From mortgage-backed securities to municipal bonds, sovereign debt to CDOs, ratings agencies have notoriously mispriced risk over the last decade, and nearly all of us have paid the consequence.

Yet they not only remain, but prosper. They're still used by every major firm in America (if not the world). And they're left largely untouched by regulators and investigators. Why?

Last month, a long-running Senate study determined that over 91 per cent of the AAA mortgage-backed securities issued from 2006-2007 have since been downgraded to "junk" - BB or lower. Surely, a screw-up this gigantic can only be attributed to some extremely smart people. A man off the street would have better odds just flipping a coin. Only geniuses can be so, so wrong.

In fact, that's the best explanation for what happened to the "big three" ratings agencies. They were run by brilliant quantitative economists, with models derived from statistics dating back decades. Whether the housing statistics from the Great Depression were lost, or if the raters willfully left them out of their models, we don't know. But there was no model in use that took into account a generational crisis - one where home prices might drop 20 per cent in one year. So investment bankers were able to stuff securities full of bad loans and still get their precious AAA ratings.

"Their quantitative models appeared to have a Mensa-like IQ of at least 160," bond legend Bill Gross sums up nicely, "but their common-sense rating was closer to 60, resembling an idiot savant with a full command of the mathematics, but no idea of how to apply them."

"It's easier to be smart than good," we also wrote in Empire of Debt. "Smart men get elected to high office. They run major corporations ...

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"But it is virtue, not brainpower, that pays off."

Of course, all the raters and bankers were more than just too smart for their own good. Their lack of virtue exposed a conflict of interest obvious to any functional adult:

  • investors want AAA-rated securities;
  • investment banks deliver whatever their clients want;
  • investment banks pay ratings agencies for their services;
  • the service of a ratings agency is to rate securities.
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First published in The Daily Reckoning on August 31, 2010.



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About the Author

Addison Wiggin is the editorial director of The Daily Reckoning, and executive publisher of Agora Financial. His second editions of international best-sellers Financial Reckoning Day Fallout and The New Empire of Debt. His third book, The Demise of the Dollar ... and Why its Even Better for Your Investments was updated in 2008, the same year he wrote I.O.U.S.A.

Creative Commons LicenseThis work is licensed under a Creative Commons License.

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