Earlier this week in Crikey, Adam Creighton considered the role of the three large ratings companies, Moody’s, Standard & Poor’s and Fitch, on the global economy. The conclusions reached were correct, but Creighton let the ratings agencies off the hook — their failings and abundant conflicts have not only been wildly inaccurate in terms of corporate bonds and government debt — but the ratings agencies share a large degree of blame for the damage caused by the global financial crisis. This was because the rating agencies almost fell over themselves lining up to rate toxic mortgage investments “AAA”.

To be fair, the ratings agencies were far from the only villains during the global financial crisis, but their actions — combined with appalling government regulation, certainly made matters worse.

Just as background, traditionally, the role of the ratings agencies was to provide investors with their views on the ability of corporate lenders to repay bondholders. The first ratings agency, Moody’s, was founded by shrewd corporate analyst John Moody in 1903 and its model was to charge investors for advice regarding the credit-worthiness of bonds. In the 1950s, the ratings agencies changed their model — instead of providing unbiased advice to investors paid for by investors, they started charging issuers. This was commercially expedient, but led to a fairly obvious conflict — that is, if the ratings agencies provided unfavourable ratings, they would run the risk of not receiving much more work.

The incompetence of the ratings agencies is certainly nothing new. As Creighton correctly noted, none of the rating agencies issues a warning on Enron, Tyco or Worldcom before all three imploded in 2001. Not one word of warning. Almost comically, the ratings agencies would review their ratings often after a company had filed for bankruptcy.

But while they failed dramatically in the early 2000s, the ratings agencies’ true folly wasn’t exposed for a few more years. That was in their other area of “expertise” — the rating of financial instruments such as collateralised debt obligations (more commonly known as “CDOs”).

You can create a CDO on anything, but what investment banks did by the hundreds of billions during the 2000s was create CDOs made on mortgages made to American householders. In short, home owners or property investors would take out a mortgage, that mortgage would often then be on-sold and packaged together with a large number of other mortgages to create a mortgage backed security (this happens in Australia as well incidentally, and is backed by the federal government and taxpayers to some extent).

This is where it gets more confusing.

Investment banks would then take these mortgage backed securities and chop them up into different pieces — those pieces would be combined with other similar pieces from other mortgage backed securities and on-sold to investors. The riskiest piece would be called the “equity” portion. That part would pay a higher yield, but would generally be harder to sell as the risks attached were high. (As the GFC reached a crescendo, the equity portion would be bought by hedge funds who were selling other parts of the debt in an arbitrage play).

There would then be a mezzanine part of the instrument, which would be rated BBB (just above junk status) and would pay a lower yield than the equity part, but still a relatively high yield. Then there would be the “super senior” part of the instrument, this was rated AAA by the ratings agencies, on the basis that it was super safe — virtually risk-free. It was assumed by the ratings agencies and banker that this super senior portion would virtually never default, partly based on the principle that property prices never fall.

The only problem was this so-called AAA super-senior debt wasn’t risk free at all. Instead, it was often loans made to poorer home buyers with little or no down-payment (often these home buyers provided little documentation, and the mortgage featured a lower initial “teaser” rate, before increasing). The reason ratings agencies deemed these instruments AAA was because they were a diversified bunch of toxic loans, taken from various mortgage backed securities. According to the ratings agencies, a bunch of toxic loans combined together suddenly became a gleaming security. Of course, the fact that the ratings agencies were paid by the banks issuing the loans presumably had nothing to do with the favourable ratings. (Most issuers required two ratings for securities, so with three ratings agencies fighting it out, forum shopping inevitably occurred).

The other problem with ratings agencies, apart from being paid by those were being rated, was that they were staffed by those considered somewhat lesser than others who worked on Wall Street staff, possibly due to ratings agency staff being paid a fraction of what their Wall Street colleagues received. As Joe Nocera and Bethany McLean noted in All the Devils Are Here: The Hidden History of the Financial Crisis, as the crisis was brewing in 2007, Moody’s wrote “the best way to look at the main financial institutions i.e. the pillars of our system. In our view, their ability to withstand shocks is very high, perhaps higher than ever.” Within a year, those very pillars almost all needed to be bailed out by taxpayers.

Not long after producing that sage analysis, Moody’s claimed that there were “no negative rating implications … as a result of [the banks’] involvement in the sub-prime sector”. Shortly after, virtually all such instruments, once rated AAA, were reduced to junk status.

Of course, there is a reasonable argument to be made that fund managers, who are deemed sophisticated and themselves are handsomely paid, should be doing their own research, rather than relying on ratings agencies, who have long lost any semblance of independence, and whose credibility vanished long ago. That is no doubt true — but the actions of the ratings agencies certainly worsened the problem.

By turning otherwise toxic securities into AAA-rated instruments, the agencies used their brand name (or more specifically, the AAA brand name) to generate investment in a sector that did not deserve such investment. The AAA ratings allowed CDOs (and even worse, synthetic CDOs) to be created and sold. This caused a great deal more loss than would otherwise have occurred. Without the AAA ratings, the banks wouldn’t have been able to sell the CDOs, which meant that the mortgage companies wouldn’t have been able to sell mortgages, which meant that home owners who couldn’t afford to purchase houses, wouldn’t have been able to buy them in the first place.

So while the ratings agencies may have blundered their way through corporate bonds ratings, they caused billions of dollars of damage in their flawed ratings of mortgage debt instruments.