If knowledge is power, ignorance sure ain’t bliss

As I wrote at one of my old blogging homes, one of the biggest causes of the subprime mortgage crisis was not knowing what was being invested in. A system was created where the true nature of investments are hidden from those putting their money on the line. Bond rating agencies are supposed to be working to help investors gauge the quality of various opportunities.

…these ratings agencies know things every other investor never gets to find out. You know if you’re buying or selling junk bonds or pushing a strong investment because they told you so. Their job is to use the inside information they have to good advice to investors so they can properly understand the risk they are taking on.

Now if you were looking for inside information, let’s say on a boxing match you wanted to bet on, who would you want to get that inside information from? Would you rather get that information from a person who you paid, or would you rather listen to the guy your bookie has paid? The guy you paid has a financial incentive to give you the information that will help you win the bet. The guy who your bookie paid has a financial incentive to give you the information that will help your bookie win the bet. I’d listen to the guy who has my interests in mind.

Unfortunately, Moody’s, Stanard & Poor’s and Fitch all are paid by those looking to have their securities evaluated. Therefore, the three major firms are competing to be the best at attracting customers and getting those customers money. In this case that’s the sellers of securities. In effect, there is a financial incentive to give the highest ratings in as many cases as possible as that will make your firm more money.

Because the only information available comes from a source that is in the sellers pocket, it’s very hard to come by accurate information about what investment is what. Former Treasury Secretary Paul O’Neill made a perfect analogy for what has come of this system.

If you have 10 bottles of water, and one bottle had poison in it, and you didn’t know which one, you probably wouldn’t drink out of any of the 10 bottles; that’s basically what we’ve got there.

The results of not knowing have already been fairly devastating. For Bear Stearns, it seems, the panic about how bad their financial situation might be was as much a cause of their collapse as the actual finances. In economics perception is reality and when you don’t know, you’re left only able to rely on guesses. Next thing you know, you’re at the losing end of an informational cascade.