Next shoe to drop? Public finance. Muni, sovereign and state ratings are a backwater in the agencies. The slowest of the slow and dimmest of the dim are sent to these pastures and the amount of analysis that goes into the munis is close to zero. Every state in the country is investment grade and all but one are in the A category or above – yet many states sit on the precipice of default. Ireland was in the double-A category as recently as last month. Just as with the intricacies of complicated CDOs and the like, the agencies don’t know how to handle debtlike obligations such as pensions – the very things that are dragging cities and whole states under.

And when bond yields were falling, there was an incentive to construct higher-yielding “risk-free” securities. Didn’t work very well. :)

The demand for AAA is down to the continued misrepresentation of “no credit risk= no risk” and regulations that reinforce that view.

We desire security in an uncertain world, so we invent a host of strategies (diversification, hedging, collateralization, structured bonds) that pretend to construct a risk-free portfolio out of securities that are anything but. None of these strategies are perfect, unfortunately, so we make ourselves feel better by tacitly agreeing to ignore their flaws.

If people were to stop paying a premium price for annuities and insurance products, and embrace the risk/return gamble, then there would be less demand for AAA rated securities and less motivation to manufacture them. But that flies in the face of our nature.

Credit-risk free=risk-free. All AAA is meant to mean is that there is a high probability that the obligation you have bought will pay out as per the contract assuming you hold to maturity. If you buy a US 30 year bond then AAA means if you hold it for 30 years you will collect all the coupons and get the principal back. It most certainly does not mean it is “safe” or “risk-free”. If you think it is then I suggest you have a look at the volatility on Treasury bonds over the last couple of months. The very simplest AAA instrument is one where you give me 100USD and I promise to pay you 0USD in return. There is zero probability of me defaulting on that contract and you are 100% guaranteed to receive that in 6 months time.

They are “too complex” to value. Hands up anyone who thinks it is harder to come up with a model that gives an accurate future price for Citigroup as opposed to one of their structured notes? Equities fundamentally are the most complex products to value objectively, the reason we know the price is because we can see it on an exchange and know if we hit yes we are more or less going to get that price. Liquidity difference not complexity.

Also there is no reason why credit risk should be static. No one expects other risks to be. Answer to all this nonsense is to stop privileging credit risk over other risks. Stop mandating that investors can palm off their responsibilities for analysing the risk – not just credit risk – and returns to the rating agencies and stop using discrete bands with a line below which all the sheep have to mechanically ditch the bonds.

PS Is this the same FT Alphaville that thinks deposits at banks are assets? Or that the ECB has a new rule allowing banks to post their **liabilities** as collateral for loans? I wonder if S&P will be linking to that article. At least Mr Salmon is honest enough to show any original errors along with the corrections!