I’ve always curious about the role of the credit rating agencies (you know “Ireland has been degraded to AA, this has been graded a junk bond “– that’s BB by the way). And now, thanks to Addison Wiggins and The Daily Reckoning, I know. And more importantly I know why it matters to us all.

There are 3 main agencies – Standard & Poors, Fitch, and Moodies. All reside in New York. All staffed by geniuses, who do complex projections on the worth of sovereign debt, the bonds and credit worthiness of companies listed on the New York Stock Exchange, London Stock Exchange etc. Their ratings give us a clue as to the financial strength of the companies we (and our pension schemes etc) invest in. So AAA is the best, BB is junk. We thus have information how to best put our hard earned, after tax income. They are supposed to provide a clear playing field for all investors.

But they haven’t. They have mispriced risk over the last decade, and it has cost us all dear. A Senate study showed last month that over 91% of the AAA rated mortgage backed securities issued 2006-2007 have been downgraded to junk. S&P rated Iceland A+ three months before its currency collapsed. Only really clever people can muck it up this badly – hence the second bit of the title. All three rating agencies are run by brilliant quantitative economists, with Mensa levels of IQ and zero common sense. No model they used took account of generational crisis – all models were too short term. As I’ve pointed out before – study history!

Still they pontificate, and are used by just about all major firms and countries in the world. Why – because those firms offer securities which they want to be sold – to you and me, directly or otherwise. So we need information to encourage us to buy them. Would we buy if we thought our money was at far more risk, or would be expect more reward in terms of interest if we feared we would lose our capital? Of course we would, but that would make the cost of capital for the issuing firms that much higher, so the issuer wants a good rating.

Here’s a good rule that accountants use (well I do anyway). You should, too. Follow the money. Who gets paid by whom for what?

How do ratings agencies get paid? The big three get paid by the firms issuing the securities. That’s not to say the agencies are in cahoots with these firms. They are not; it’s simply a flawed model. Too cosy.

Other agencies do a different job – some would say better. Egan Jones is paid by the buyers of the bonds it rates. Does that sound better to you?Should you trust the truly important investments in your life to this circle of self interest? Ratings agencies, investment banks et al don’t bother with small companies, commodities, smaller funds and other such things with limited potential to make them money. Not you – them. Should you.

So by all means look at the barometers shown by the agencies, because that will tell you what everyone else is thinking, but don’t trust your widows and orphans fund to anything you don’t understand, or where you have to rely too much on someone else’s opinions. Especially if you aren’t a genius and they are.