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Why did financial institutions believe the AAA ratings?

Yves Smith, author of “Econned” and the Naked Capitalism blog, offered this explanation this morning when she was asked why financial institutions “blithely accepted the AAA ratings or otherwise took the word of the ratings agencies and the demand of the market itself as sufficient to invest in products that were claimed to be safer than sovereign bonds”:

There is a bit of urban legend in this. The biggest need for AAA paper was not end investors, but traders who used AAA paper as repo, which is collateral for loans. Money market funds were big repo lenders, and dealer banks would lend to each other using repo.

The reason was they needed to post collateral for their derivatives exposures, and they could use AAA paper directly as collateral or post AAA paper as collateral to another party, get cash, and use that cash as collateral.

So this was much less about dumb investors relying on AAA ratings in the way it is presented in the popular press. You might query why people would be so confident in AAA paper for repo, but most repo loans were very short term (a month is very long in repo land, most loans are overnight to a week). It was only when AAA rated CDOs would get downgraded from AAA to CCC (junk) in a mere day that market participants realize how risky some supposed AAA rated paper was even for such short term loans.

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