AAA ratings: a 'grim' fairy tale

You can pick your metaphor. It's like a student who pays his teacher to grade his papers. Or a plaintiff paying the judge's salary.

Cultural differences only exacerbated the problem. Investment bankers might pay the ratings agencies, but it's the bankers - by selling those securities the agencies rate - who make the big bucks. It's quite common for a junior man at a ratings agency to one day work for Goldman Sachs or JP Morgan (though not the other way around).

Thus, there is further incentive, though widely unspoken, for raters to play ball. After all, what's the Wall Street life expectancy of an S&P analyst with a ball-busting, no-games reputation? (This same relationship, by the way, is also a real issue with the SEC.)

And so the game was played. Together, the rater and banker would decide what combination of loans garnered what rating. Of course, the banker wanted AAA notes to sell to the Icelandic government or a Fidelity retirement fund, and the rater wanted the banker's business ... if not to become a banker himself one day. The models played along, too, having never known a crisis like the one that was around the corner.

Even when things got really crazy - when there were just way too many bad loans to make a AAA security - bankers and raters found a solution. They split the security into different partitions of risk, each with separate yields, but all under the same rating. They called these "tranches," as if it weren't complicated enough - a French word for a "slice" or "portion".

Shareholders and taxpayers, of course, paid the biggest price for the subprime fallout. Bankers have taken a few jabs, too ... sort of. But ratings agencies managed to emerge largely unscathed. The big three, Moody's, Fitch and S&P, are not only still in business, but they remain highly relevant.

Even as we write, traders are waiting to hear from them with bated breath ... the fates of debt-strapped euro-nations, Greece in particular, is in their hands. S&P likes to boast that they insist on sending not one, but two ratings analysts to every country to help determine its credit sovereignty. "It's been our practice, and it's worked well," said S&P's John Chambers.

S&P rated Iceland "A+" in March 2008, about six months before its currency collapsed.

Late last month, Chambers helped knock Spain down to AA, a "bold" move, defying Moody's and Fitch's AAA rating on Spanish debt. "Here's a country," Bill Gross continues, "with 20 per cent unemployment, a recent current account deficit of 10 per cent, that has defaulted 13 times in the past two centuries, whose bonds are already trading at Baa levels and whose fate is increasingly dependent on the kindness of the EU and IMF to bail them out. Some AAA!"

That's the biggest bond investor in the world calling agencies out with a crystal-clear example of their inability to function. Yet global credit still lives and dies by their ratings.

Despite all the obvious, common-sense issues - incompetence, conflict of interest, past performance - Congress is turning a blind eye to this tawdry corner of the financial services industry.

Even the free market seems to have failed in this instance. There are more than just three ratings agencies in this world, after all. Some of them even managed to do their jobs. "Second tier" agency Egan Jones comes to mind. Its analysts are paid by the buyers of the securities it rates, not the issuers. What a novel idea! Yet Egan Jones is not the No 1 agency in the world, for reasons we can't explain.