Why stock market investors are better than the ratings-obsessed bond ninnies

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It all began with the ratings agencies giving their AAA imprimatur to collateralized debt obligations built atop vast mounds of suspect mortgages. And now the crisis is deepening with S&P and Moody’s yanking away ratings at the most inopportune times, as they both did Monday night to insurer AIG.

My first temptation is to yell, as has been done before, This whole mess is the ratings agencies’ fault! But that’s not quite right. As I wrote in a column back in March, it’s markets’ fault for paying so much heed to their danged ratings. The ratings are information, and if they were simply treated as such they wouldn’t be a problem. Instead, they’re used as a crutch–by government agencies, by bond investors, and–it turns out–by participants in the credit default swap market. So when S&P and/or Moody’s downgrades, you get this Pavlovian response.

It all makes one’s admiration grow for the stock market, which certainly gets things wildly wrong on occasion, but at least operates on the principle that risk comes in an infinite number of gradations. Instead of just: AAA, investment grade, junk.

The great fiction of debt markets has been that there are risk-free, or almost-risk-free, investments. No such thing. And believing that there are can only lead to trouble. Just contrast the relatively calm reassessment of risk that went on in the stock market on Monday with the craziness in debt and derivatives markets.

Matt Welch wrote a funny article for Reason magazine in July about how the victims of the dot-com crash of 2000 (himself included) simply sucked up their losses and moved on–and didn’t cause a global financial crisis in the process. He painted this as a Gen X thing (“Say what you will about Generation X, but we were never too big to fail”), and maybe there’s something to that. But I think it’s also that stock market investors are grownups, while debt market participants have been pushed by regulation and by custom into behaving like a bunch of ratings-dependent weenies.

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