01/02/09 - Online.WSJ by Robert Rosenkranz
A bit wonky, it explains why the world invested in bad loans, and why we are in trouble now.
[edited] [ There are only a few government certified rating agencies, including S&P, Standard and Poors, and Fitch. ] Their ratings on bonds determine the amount of money (capital) that a bank by regulation needs to set aside for expected losses.Read the rest ... A part of the story at "We Guarantee It" about the housing and financial crisis.
Ratings have a profound influence on how financial institutions invest their assets. Regulations make the rating agencies the de facto allocators of capital. Every participant in the financial system has every incentive to group and slice assets in ways that maximize their rating, not their fundamental soundness.
[ Large capital requirements (more money set aside) means owning fewer bonds and making less money on the coupon payments. ]
The $6 trillion structured finance business serves mostly to improve ratings. Subprime mortgages and all manner of other risky loans would deserve a "junk" rating if taken alone, and require high capital reserves.
The structured finance people bundled these assets and sliced the bundles into "tranches" [layers of repayment priority]. The rating agencies gave AAA ratings to 85% of the tranches by value, and gave "investment grade" to another 14%, thus turning lead into gold through ratings alchemy.
Learn finally what a "tranche" is, and amaze your friends at the next party.