MORE ON RATINGS….Speaking of rating agencies, I want to highlight a single passage from the Roger Lowenstein article that I blogged about below. It’s about how investment bankers create complex financial instruments that receive high ratings:

Credit markets are not continuous; a bond that qualifies, though only by a hair, as investment grade is worth a lot more than one that just fails….The challenge to investment banks is to design securities that just meet the rating agencies’ tests….”Every agency has a model available to bankers that allows them to run the numbers until they get something they like and send it in for a rating,” a former Moody’s expert in securitization says.

Go ahead and call me a rube, but is this for real? The rating agencies just hand over their models to the Wall Street rocket scientists so they can probe for every weakness and tweak every loophole in order to put together a package that — just barely! — meets the agency’s parameters for a high rating? Does this sound like a recipe for disaster to you? It does to me. Is it the kind of thing you think would happen if the agencies were more interested in providing honest ratings than in attracting lucrative Wall Street business? I don’t.

Maybe the real bubble of the last few years has been a rating agency bubble. And maybe now it’s popped. If that’s true, and if we don’t do anything about it, then for a large class of investors the only realistic option is going to be a complete halt to investing in complex securities. After all, there’s no way for any but the most sophisticated fund managers to understand them, and no one else can be trusted to give an honest opinion about them. And if complex instruments become too toxic for pension funds and local governments and mainstream money managers, then the market for them essentially goes away. Which is a bad thing, right? Because those complex instruments really do serve a purpose by reducing friction in financial markets and making more money available to more people.

So what do we do? Regulate the rating agencies? Demand greater transparency? Just amp up capital requirements and leave the rest alone? Or what?