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The rating agencies are swift to point out that they do not perform due diligence on the data they use and take no responsibility for unearthing fraud; they merely provide an opinion. In past legal battles, rating agencies successfully claimed journalist-like privileges, refused to turn over notes of their analyses, and continued to issue opinions. Independent organizations exist, however, that perform rigorous due diligence for a fee. Underwriters can hire them, and rating agencies can demand to see the results.Yet it seems the rating agencies failed to do so for many structured finance transactions.The rating agencies protest they are misunderstood rather than miscalculating when it comes to rating structured products.They claim the market misapplies ratings by expecting ratings to indicate market price and liquidity, but the former are merely symptoms of the real problem. They take data at face value, slap a rating on a dodgy securitization, and pocket a fat fee.

The Bank for International Settlements (BIS) and the Federal Reserve (Fed) may have embraced the rating agencies because these institutions are chiefly made up of economists. The Securities and Exchange Commission is loaded with lawyers. I do not expect lawyers to be rigorous in their analysis, but I expect more of the BIS and the Fed. While there is such a thing as “junk economics,” economics itself is not considered a science. Even so, just because lack of rigor permeates economics, economists should not be allowed to let this seep into other fields, particularly when there is a scientific methodology that can be used as a basis. When they adopted the rating agencies labels as benchmarks, the BIS, Fed, and SEC enabled junk science.

Although they shouldn’t, many investors rely on the rating and the coupon when buying structured financial products. Whereas Warren views an investment like a business, many investors view their jobs as getting an investment meeting consensus. That is similar to allowing the manic-depressive Mr. Market to tell you the right price. If you do not understand the value, neither Mr. Market’s prices nor (sadly) the rating agencies will help you understand the value of a structured product any better. Many money managers feel buying a AAA investment is prudent; but if they do not understand these complex deals, they can quickly lose a chunk of principal.

Problems are not limited to mortgage loan securitizations. Ratings on leveraged synthetic credit products are often misleading, too. For example, when the products first appeared, I pointed out the triple A rating should never have been awarded to constant proportion debt obligations (CPDOs). These products are largely leveraged bets on the credit quality and market spreads of indexes based on U.S. and European investment-grade companies.

The high leverage of the products related to market risk puts investors’ principal at risk. Investors essentially take the risk of the first losses on leveraged exposure to the indexes, and that is the exact opposite strategy to Warren’s margin of safety. “Once again,” I told the Financial Times in November 2006, “the rating agencies have proved that when it comes to some structured credit products, a rating is meaningless. All AAAs are not created equal, and this is a prime example.”11

After rating an early CPDO transaction triple A, Moody’s was criticized by industry professionals, including me. Moody’s then changed its rating methodology, applying a different standard for subsequent transactions.12 Investors were attracted by the AAA rating and the high coupons. The investment banks selling them were attracted to upfront fees of 1 percent plus annual servicing fees of up to 0.1 percent.

I thought the rating agencies may have been turning over staff too quickly and using incompetent rookies—who could be pushed around by aggressive highly paid investment bankers—to rate these deals. In May 2007, the Financial Times put Moody’s actions in the harsh glare of a newly