While it is the duty of ratings agencies to assess investment risk and provide a clear playing field for investors of every kind, we all know that they have done just the opposite. From mortgage-backed securities to municipal bonds, sovereign debt to CDOs, ratings agencies have notoriously mispriced risk over the last decade, and nearly all of us have paid the consequence.

Yet they not only remain, but prosper. They’re still used by every major firm in America (if not the world). And they’re left largely untouched by regulators and investigators. Why?

Last month, a long-running Senate study determined that over 91% of the AAA mortgage-backed securities issued from 2006-2007 have since been downgraded to “junk” – BB or lower. Surely, a screw-up this gigantic can only be attributed to some extremely smart people. A man off the street would have better odds just flipping a coin. Only geniuses can be so, so wrong.

In fact, that’s the best explanation for what happened to the “big three” ratings agencies. They were run by brilliant quantitative economists, with models derived from statistics dating back decades. Whether the housing statistics from the Great Depression were lost, or if the raters willfully left them out of their models, we don’t know. But there was no model in use that took into account a generational crisis – one where home prices might drop 20% in one year. So investment bankers were able to stuff securities full of bad loans and still get their precious AAA ratings.

“Their quantitative models appeared to have a Mensa-like IQ of at least 160,” bond legend Bill Gross sums up nicely, “but their common-sense rating was closer to 60, resembling an idiot savant with a full command of the mathematics, but no idea of how to apply them.”

“It’s easier to be smart than good,” we also wrote in Empire of Debt. “Smart men get elected to high office. They run major corporations…

“But it is virtue, not brainpower, that pays off.”

Of course, all the raters and bankers were more than just too smart for their own good. Their lack of virtue exposed a conflict of interest obvious to any functional adult;

• Investors want AAA-rated securities
• Investment banks deliver whatever their clients want
• Investment banks pay ratings agencies for their services
• The service of a ratings agency is to rate securities.

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% unemployment, a recent current account deficit of 10%, 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.

Even if American investors are content to continue this charade, the Chinese are not. An upstart Chinese ratings agency, Dagong Global, has begun to offer a competing perspective. (Check out the rating on lucky nation #13 in the chart below!)

There’s one easy takeaway: You still can’t trust Wall Street. The same players and the same rules that created this mess – largely for their own benefit – are still a part of the game.

The other pill is a little harder to swallow. In the current market environment, the individual, independent investor has the best chances of long-term capital appreciation when he invests outside of “The Wall Street Fandango.” When it comes to the truly important investments in life, leave the indexes, blue chip stocks, sovereign bonds and super funds to lower Manhattan.

Ratings agencies and their banker clients do not bother with small companies, commodities, smaller funds and other securities that have little potential to make them large amounts of money. What’s more, they have no stake whatsoever in the status of your small- to medium-sized business, your family, your education or your local under-the-radar investments.

It’s in these arenas, where Wall Street has no dice to roll and no purses to snatch, where your failure or success is determined by little more than willpower, wit and some luck. That’s the best a good investor could ask for.

Addison Wiggin,
for The Daily Reckoning