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The Risk-Return Principle: What the heck happened to Econ 101?


Risk and return - are the laws being broken?

If two investments offer the same return, but one investment is riskier than the other, then all rational investors should choose the safer investment.  Similarly, if two investments have the same risk profile, the investments should offer the same return.  

In the rare situation that two fixed income investments have the same credit rating, but one has a higher yield than the other, rational investors will buy the investment with the higher yield.  This can happen for short time periods.  However, market forces should quickly act on, and correct, the discrepancy in investment returns.  It violates fundamental laws of economics for two AAA investments to produce different returns for an extended period. 

And yet, AAA (as safe as an investment gets) rated mortgage-backed securities and AAA-rated CDOs consistently promised and produced higher returns than AAA rated U.S. Treasuries.  How is this possible?  Why didn't economists scream from the rooftops (disclaimer - I am no economists)?  Why didn't free market advocates say "this is a rigged market - in a free market these returns could not differ substantially unless...unless...

Unless the "markets" (investment banks, commercial banks, etc.) understood that the AAA rating given to CDOs meant something different that the AAA rating given to U.S. Treasuries.  Investors, of course, wouldn't understand any of this.  They would look at a AAA rating and assume that a CDO was as safe as a government bond. 

This is a shocking state of affairs and, in my opinion, an indictment of the financial institutions and the credit rating agencies.

Something is rotten in Denmark...

The Sherman Law Firm

'Disclosure: No Positions'