Yes, investors are responsible for analyzing the risk of their investments. At the same time, when it comes to the kinds of investment vehicles routinely created today, the only realistic option a lot of investors have is to trust the advice of independent experts — ones who have their own staff of rocket scientists and access to all the underlying data that makes up a modern investment vehicle.

I'd say it depends a lot on who the investors are. For instance, the officials in charge of investing public funds, IMHO, have an affirmative obligation to understand the investment vehicles well enough to make their own assessment of the risk, rather than trusting someone else.

If that means they're stuck with putting their money in bonds or index funds rather than sophisticated investment vehicles with a higher return, that's where they should be stuck. As Warren Buffett has pointed out in the past, the first rule of investing is to not lose your principal.

Even if you're a private investor with the right to gamble your stake in whatever manner you choose, it's a dumb idea to put your money in a high-yield investment with a significant chance of losing a good deal of your initial investment, or into such an investment where you just plain can't understand what the risks even are.

But when you're acting in a fiduciary manner with the public's money or with a pension fund, doing so is not only dumb, it's wrong.

In other words, don't trust the rating agencies.

Which might be good advice. Perhaps the last few years have been a rating agency bubble, and now it's popped?

> I'd say it depends a lot on who the investors
> are. For instance, the officials in charge of
> investing public funds, IMHO, have an affirmative
> obligation to understand the investment vehicles
> well enough to make their own assessment of the
> risk, rather than trusting someone else.

Of course in the midwest even a State government is limited to paying its investment guys/gals $75,000/year while the rating agencies will hire those same kids out of the State office for $150,000 after 2 years experience. Creates a bit of a problem, eh? Can you say "capture"?

Cranky

"And the banks pay only if Moody's delivers the desired rating."

Well there you have it.

This is actually nothing new. The Washington Post did a story years ago about the rating agencies' conflicts of interest. Sovereign ratings are also subject to the whims of which agency a country decides to do does business with.

Kevin - I don't think anyone should blindly trust the rating agencies, to the point of "I have no frickin' idea what's going on here, but Moody's gave it an Aaa rating, so it must be OK."

If you understand the game, using Moody's to help you decide which players to invest your money with is one thing. But if you don't understand the game, you're better off not playing. I really don't see a situation in life where this is a bad rule.

Don't trust the ratings agencies? Geeeee - but it was those good Wall Street folks that told me to buy ENRON!

And look at all the money we all made on that.

"If it turns out that those independent experts have enormous incentives to help the bankers game the system, that's a problem"

In other words, they're not independent.

Perhaps the last few years have been a rating agency bubble...

As Mason put it in his Sep 2007 testimony:

The regulatory use of ratings thus has changed the constituency demanding a rating from free-market investors interested in a conservative opinion to regulated investors looking for an inflated one.

Same thing I said over on DeLong's site: it simply isn't possible to run a modern economy if /everyone/ is expected to be an expert in /every/ aspect of every transaction they undertake to the point of being able to outthink and see through every instance of sharp dealing and fraud. Similarly if they have to double-audit every action of the supposedly independent auditors that have been socially (and in many cases legally) blessed as disinterested neutral parties. If it is true that that is actually the situation and there is nothing to be done about it, then it is time for some very heavy-handed Federal regulation and some serious restrictions on the salaries paid in that industry.

Cranky

" the only realistic option a lot of investors have is to trust the advice of independent experts "

Let's see. The independent experts say something about entitlements, and I believe them and order up a significant restructuring of entitlements. Things blow up on me.

How can I go back to the monopoly expert and get my trillion dollars back?

This is Kevin Drum and his version of God. God is someone who looks experty, and therefore God should be trusted. If the experty type person screws up, then God junior, the government, will fix things.

*

mhr - during the Clinton years we had Whitewater, Travelgate, the Clintons' supposed murder of Vince Foster, not to mention the Lewinsky scandal/impeachment.

Mind you, President Clinton's team had some real crises to deal with too, such as the international banking crisis of 1998 that everyone forgets because...because they had good people who knew what they were doing, and kept things from going haywire.

When actual crises crop up these days, there's just a bunch of crony capitalists and free-market ideologues in the front office, debating with each other over whether to help just the big shots, or to help nobody at all. Usually the first group wins.

Keep in mind also that it's not just a question of the borrowers and lenders by themselves, but the leveraging of financial instruments through those loans and their subsequent effect on almost everyone, not just the principals. IOW, it isn't like someone buying rotten food that hurts only themselves.

One of the first rules of investing, for anybody at any level, is never to invest in anything which you do not understand.

Does that greatly limit the number of potential investment vehicles for most people? Yes, of course it does. Is this necessarily a bad thing? NO!

There are thousands of investment vehicles out there (individual stocks, mutual funds, index funds, ETF's, bonds, CD's, etc.) which deliver perfectly acceptable, if not downright excellent, returns with relatively low risk. After all, the risk attached to TIPS, bonds guaranteed to outperform the rate of inflation (thus guaranteeing you a positive net return), is nil.

It's only when people get greedy and seek unreasonably high returns (without regard to the fact that this will necessitate accepting higher risk) as well that the creation of impenetrably complex financial instruments even takes place.

In this case, you had large financial corporations and hedge funds who make a large portion of their trading profits by using borrowed money (leverage) to trade illiquid financial instruments with tiny profit margins (often less than a penny on the dollar) at very high volumes get snared by their own ignorance of the basic concept of risk versus reward.

They were blinded by their own greed, plain and simple...

Everyone is looking for that which does not exist-the independent expert to tell you what to do with your money. The real problem is that too many people think this mythical being really does exist.

If you don't understand what you are investing in, then don't do it.

Another fucking Mickey Kaus post from "call me a dissenter" Kevin.

Why can't you link to Brad Friedman from the Brad Blog instead of Brad Freaking DeLong, too, Kevin, if you need to quote a Brad?

Or quote one of your effing cats?

You're becoming more neo-Kausian all the time.

Beyond that, Kevin, it's hard to tell which side you finally come down on here.

This is like a Dallas Morning News editorial: "On the one hand, on the other hand."

Or, as I extend that, "Shit on the one hand, the Dallas Morning News on the other."

Take a stand on something, and do so in clear, nonconvoluted English.

I disagree with Kevin Drum here (and mostly agree with Brad DeLong, which doesn't happen that often). There haven't been big losses incurred in CDOs by unsophisticated investors who were relying on the rating agencies: the big losses have been incurred by big banks that were holding lots of improperly hedged inventory and by hedge funds that made speculative bets that went wrong. CDOs aren't sold in $5000 increments to widows and orphans, you know. So it just isn't true that CDO purchasers have no choice but to rely on the rating agencies.

True, there have been a few counties or other local governments that lost some money, and possibly the affected states should implement stronger guidelines for investment of local government money. I can assure you that counties in New York State aren't permitted to invest in anything that has been affected by the credit crisis.

y81 has it right. Moreover, those large investors had access to resources that strongly suggested they were at far greater risk from CDO/subprime investments than the standard ratings indicated. That they did not avail themselves of those resources, or chose to ignore them, should be a strong clue as to what is wrong with this picture.