Your comment makes total sense [1] : I started looking at these collateralized debt obligations (i.e. CDOs) back in 2002. That was around the time of the first

Your comment makes total sense [1] : I started looking at these collateralized debt obligations (i.e. CDOs) back in 2002. That was around the time of the first 'crash' in these structures (CBOs : structures backed by High Yield Bonds). The basic error with CBOs is that the rating agencies allowed the structures additional diversity 'points' for investing in different sectors (a decent idea), but then segmented the market so that many, many different telecom-related businesses got put in different sectors. The telecoms bubble then proceeded to wipe out about half the contents of each CBO. Why didn't anyone point out the problem? Because the investment banks, having been given the published specification of how the Rating Agencies would model any hypothetical structure, went about optimizing the portfolios of bonds to maximize the 'ratings arbitrage' available. Your point about migration of the underlying risks is spot-on. The rating agencies looked at the historical performance of each of the classes of risk. For CBOs, once people saw how the rating agencies would give them points for particular sorts of High Yield bonds, suddenly telecoms (& fibre, & cable, & satellite, & etc..) companies found it very easy to raise what were known in the market as 'CBO bonds' : bonds that no rational investor would want, but would be very appealing for a structure to buy (since it would help its ratios). Similarly, once there were evening classes in how to improve your FICO score, the whole history of sub-prime borrower repayment statistics became irrelevant. The manipulation of the fundamental inputs to the models by 'good hardworking Americans' was rampant... But the Rating Agencies were being paid well to continue to rate structures (at a crazy pace), and the Investment Banks were in no hurry to point out that the models should be harsher. Part of the whole problem, though, stems from banking & insurance regulations that mean that its very cheap (from an equity capital point of view) to leverage up AAA paper. That's what drove everyone to demand AAA paper in the first place. And the AAA designations is/was handed out by rating agencies that now claim it was 'free speech' and they're not liable for anything. As for the moving target aspect : Investment Banks are continually trying to innovate, since that's where it's less competitive, and the margins haven't been competed away. They would ask Rating Agencies to look at new products all the time. If all the Ratings Agencies were too conservative (or cautious), then the product wouldn't work, and would be abandoned. However, if one of them could be persuaded to come up with an exploitable methodology, then they would get all the business... And before anyone says : Ahh, Wall Street is just about the exploitation of loopholes, think about examples from hacker-space : SEO comes to mind... [1] except for the example of BRK : That's a bit of a special business. Reinsurance is a tricky thing, and it's possible to look very smart until you discover you're an idiot. AXA looked pretty smart, until... Better examples would be AAA industrial businesses, or a hard-asset business, for instance.