Before I come to the point I wish to stress upon, I would like to share a small anecdote about something huge that happened a few years back that affected all of us deeply.
Let’s Look Back At The 2008’s Financial Crisis
I will request you to strain your brain a bit and briefly look back at the 2008 financial crisis. In simple terms, what happened was, to fuel growth in the 90s, banks started giving home loans at high interest rates to a lot of shitty people who couldn’t afford those homes. And for the first time, thousands of these loans were being packaged together into a financial instrument called bonds by investment bankers, and then these investment bankers started getting these shitty bonds, made up of shitty loans, to be rated as top notch ie. AAA by credit rating agencies.
And then, a lot of investment bankers went out on the street selling these bonds to all kinds of funds (including pension funds). And then, the demand for these bonds on the Wall Street increased, for they were well rated, and when that happened even shittier people started getting loans for their homes, so that their repayment plan could be put in a bond and sold by investment bankers to funds.
And the bankers actually ended up selling billions of these bonds. As a result, when the loan agreements matured and people had to repay, many of them started defaulting. And when that happened, the bonds lost all their value, and as a result, a huge number of people who had invested in these safe funds, lost most of their life savings, and that, in my opinion, was an ugly thing.
And The Reason All Of This Was:
- The fund owners trusted the judgement of the rating agencies, who screwed up by rating these shitty bonds as AAA.
- The investment bankers went out and sold these bonds like crazy.
Now the problem in the fundamental construct here is that neither the rating agencies nor the investment bankers were cold hearted ass****s, but they were just playing in accordance to their visible incentives.
The agencies had to rate the bonds because if they didn’t, their competitor would and they did not want to miss out on business.