We’re apparently meant to understand that the worst of the credit crisis is over, or nearly so. Federal Reserve chairman Ben Bernanke says the markets are “far from normal” but reassures us that the smart and caring gentlemen at the Federal Reserve stand ready to increase its auctioned funds. Banks have started to lend to each other at more gentlemanly rates, narrowing the spread between inter-bank lending rates and Treasuries. All of the big wigs on Wall Street—the kind who get invited to luncheons with Bernanke—have said that we’re finally, or nearly, out of the dark woods we entered sometime last year.

What certainly seems to be passing is our very brief age of anxiety. Those who have been predicting national disaster are a bit quieter. Even the worst fears of inflation resulting from the extraordinary rate cuts from the Federal Reserve seem to be receding with the expectation that interest rates will soon enough—perhaps by year’s end—begin climbing once again. Oppenheimer’s Meredith Whitney says there are more losses to be booked by brokerages but, by the logic of contrarian investing, the attention her every pronouncement gets is an indicator that there is little investment value left in shorting these institutions. This morning on Squawk Box even Jim Chanos, the notorious short seller, indicated that he might be backing off short positions in the financials.

There’s something unsettling about how orderly this has all been. How have we passed through what many have described as the worst crisis in American finance in recent memory with so little blood spilled on Wall Street? That question may seem crass to investors in Bear Stearns, to the holders of still frozen auction rate securities, to the legions of laid-off investment bankers. But the layoffs from this crisis have not come close to those we saw when the tech bubble popped. The holders of auction rates and even Bear Stearns shares have not experienced the pain of investors in the dot coms. To paraphrase a former Kansas senator, “Where's the panic?”

At the most basic level, the critique of the ratings agencies seem to be that by assigning triple A ratings to riskier credit products, they concealed risk. This dismays the ratings agencies who believe that they never claimed every kind of credit product that bore the same label carried the same risk.

“Credit ratings are relative to the type of credit,” a credit rating official tells DealBreaker. “Different types of products have different inherent risks, and the labels reflect payment expectations within those categories.”

The ratings agencies have all but admitted, however, that by using the same labels for products carrying different levels of risk they may have left themselves open to the critique they now face. This is why they have proposed reforms such as explicit warnings and using different systems of rankings for different types of products.

By and large, Wall Street does not appear to have been fooled by the fact that CDOs and corporate bonds may have both been called AAA. The CDO market typically offered higher yields for triple A paper than the corporate debt market, implying that investors understood the risk profile was different. It wasn’t only the nature of the credit product that was heterogeneous. The pricing was as well.

Ratings agencies are the folks everyone has learned to love to hate as credit markets have deteriorated. They stand accused of damaging Wall Street investors by negligently or corruptly assigning unduly high credit ratings to collateralize debt obligations. But was Wall Street really fooled by the ratings agencies?

There is strong evidence that suggests investors in many CDOs were skeptical that a AAA CDO paper had the same risk premiums of more traditional investment grade debt. Investment-grade CDOs typically offered higher yields than similarly rated corporate bonds. But yield and price are inversely related, so this is just a way of saying that they were priced below similarly rate corporate bonds. The CDOs were rated triple A and structured to have similar payouts but priced lower.

Basic financial theory should tell anyone that this is too good to be true. Excess reward should quickly be priced away, returning profits to average levels. If higher yields continue, there is clearly some kind of discounting going on.

You can think of the higher yield for CDOs as resulting from the assignment by investors of a ratings agency error discount. The market understood that triple A did not mean triple A when it came to CDOs, and it discounted the CDOs for this errant marking.

This is not to say that the high ratings for CDOs weren’t a charade. But clearly the investors in CDOs weren’t fooled.

We began yesterday by announcing that the ratings agency scandal was showing signs of becoming overwrought. Ratings agencies, including S&P, Moody's Investors Service and Fitch Ratings, have been criticized and mocked in recent months as credit markets have deteriorated. More recently, regulators and prosecutors have announced investigations into the role of the ratings agencies in the subprime bubble and meltdown.

At the heart of the critiques, mockery and investigation is the sense that ratings agencies damaged the market by assigning investment grade ratings to securities that are now considered to assigned far lower values by much of the market. Many regard certain types of CDOs that were highly rated by the agencies as toxic or simply worthless. In the moveable feast of blame, the ratings agencies are being made to eat some humble pie and admit they made errors.

But how much of the damage to CDO investors is really the fault of the ratings agencies? Were sophisticated investors—banks, hedge funds and other institutional investors—really fooled into over-investing in these risky credit products by the high ratings assigned by the agencies? There’s good reason to be skeptical of some of the criticism coming from banks and regulators.

We explain why after the jump.

We've joined the cacophonous critical chorus on the failure of the ratings agencies to anticipate the risks involved in structured credit products and the much mocked reform proposals. But conversations we had over the weekend have us wondering whether this scandal might have become overwrought.

At the heart of the scandal is the idea that the errors of ratings agencies damaged the market by convincing investors of the safety of credit products that have turned out to be far more risky than the ratings issued for them seemed to imply. This idea of harm on the market assumes that the products did not originally trade at a discount for ratings agency error. Should we really assume the market did not price in a discount for error? Was the market really priced for ratings agency perfection? What's the evidence for this contention?

Prior to the meltdown in the CDO market, there were many who warned that the markets contained hidden dangers. Are we to believe that there was no discount priced into even highly rated CDOs for risks so publicly discussed? The proposal from MBIA that ratings for credit products come with warning labels implies that such ratings should be priced with a higher discount for error than other types of credit. But since when do our institutional investors and much vaunted efficient market need warning labels to tell it that complex and little understood investments may be riskier than simpler credits? Wasn't there an implied warning label in the very nature of many CDOs?

The fact that CDOs may now be trading lower than they did in the past is not evidence of the absence of a discount, of course. As risks become more apparent, the discount for those risks often becomes heavier. This is a risk pricing issue but it doesn't imply that those who bought under the earlier discount were misled.

This question of a discount for agency error matters. Last week we learned that New York Attorney General Andrew Cuomo was investigating the ratings agencies, and possibly considering using the dreaded Martin Act to allege fraud. The Martin Act is a powerful tool for the attorney general because it does away with many of the evidential requirements to prove fraud in the securities markets. But, from our reading, it does require the attorney general to show that the conduct of the accused caused harm to investors. A discount for rating agency error might create a powerful defense for the agencies.

It might be time to take a deep breath. It's starting to look like the ratings agencies are in danger of being scape-goated for the indulgences of the credit markets over the past few years.

Four months ago we launched The Big Idea, our occasional feature speculating about the future of finance, with a guess that Goldman might Sachs consider spinning off it’s proprietary trading group. There had been word on the street that the big pay packages received by many of the top names in private equity and at hedge funds had some within Goldman proprietary trading group feeling underappreciated. “We're hearing from investment bankers who have talked to people inside the firm that Goldman could face pressure to spin-off its trading and hedge fund business in order to realize the value of the business before its guys start to defect or strike out on their own,” we wrote.

At the time, the Big Idea made something of a splash across the financial media and was heavily discussed in the financial community. But Goldman, then trading at it’s fifty-two week high, didn’t seem very keen on the idea. But just because Goldman wasn’t willing to talk spin-off didn’t mean that some of the top guys inside of Goldman weren’t plotting their own private spin-off.

This weekend’s Wall Street Journal details the rise and departure of Mark McGoldrick, the 48-year-old founder and former head of the “Special Situations” group at Goldman. Last year, McGoldrick got a $70 million bonus, one of the highest bonuses paid by the firm and more than Goldman CEO Lloyd Blankfein's $53 million, but considered himself and his team “under-compensated.”

More After the Jump

[In the very first of our Big Idea columns we proposed something that we knew would be controversial—breaking up Goldman Sachs—but we hoped would spark discussion. And that’s what it’s done. First on the Financial Time’s Alphaville blog, then in Thorold Barker’s Lex column in the Financial Times, and over to the personal blog of Portfolio finance blogger Felix Salmon, where it was picked up by the Evening Standard tabloid. Each writer, of course, has picked up a new aspect of the Big Idea: Barker argued for transparency rather than breakup and Salmon for a leveraged buyout. But the discussion continues today in the latest edition of the Big Idea.]

Analyst Richard Bove is “toying in a recent research note with the notion of a Goldman breakup,” says Mark DeCambre on thestreet.com. DeCambre and Bove, an analyst at Punk Ziegel, both pick up with the notion that got this discussion going: Goldman seems to trade at a discount compared to the multiples the market seems willing to tolerate in smaller investment banks, hedge funds and private equity firms.

DeCambre writes:

Yet for all of Goldman's dominance, the stock is hardly loved by Wall Street. Richard Bove, analyst at Punk Ziegel, notes that Goldman trades at a steep discount to many lesser rivals -- in part because diversified financial giants, like Goldman and Citi, don't tend to get premium multiples.

Bove points out that Goldman trades at 10.4 times its projected fiscal 2007 earnings. Meanwhile, high-profile boutiques such as Lazard and Greenhill sell at multiples twice that of Goldman.

We haven’t read the Bove note yet but it seems that both Bove and DeCambre treat this as more of an intellectual lark than a serious exercise in predicting a break-up.

“Mark DeCambre admits up front that Goldman Sachs ‘isn’t considering a breakup right now.’But that hasn’t stopped Mr. DeCambre, who writes for TheStreet.com, from joining the others who have recently speculated about what such a hypothetical and unlikely breakup might mean for the hugely profitable securities giant,” DealBook notes on its item following the discussion today.

Last week, however, DealBreaker had lunch with a former Goldman Sachs investment banker who reminded us that there was a time when no-one believed that the Goldman partnership would go public. Some doubted that it was even possible to take the bank public, given the disclosure requirements and concerns about having conflicts between duties to clients and to shareholders. All that vanished, however, when Goldman did finally go public.

Could Goldman actually breakup?

“Stranger things have happened,” he said.

Splitting the Goldman Sachs Difference [theStreet.com]
Playing the Goldman Breakup Game [DealBook]

The Evening Standard decided to start asking Goldman Sachs about Felix Salmon's version of our Big Idea. And Goldman's response was apparently unfit to print.

FS vs GS in the ES [Felix Salmon]

The point of our new Big Idea feature is to get the conversation started. Our very first item is fortunately proving the concept. The question of what to do to unlock hidden value at Goldman Sachs—we suggested spinning off the hedge fund business—is getting talked about.

This morning we discussed Thorold Barker’s proposal for a Goldman Sachs Glasnost. (Risk factor: look how well openness worked out for the Soviets!) The second proposal of the day comes from future Portfolio financial blogger Felix Salmon, who thinks that the DealBreaker and Financial Times ideas aren’t radical enough.

Felix writes:

Blackstone, or KKR, or Silver Lake, or someone along those lines, should just buy Goldman already. People have been talking about the first $100 billion private-equity deal for some time now – and this could be it. Goldman is a great PE target: an undervalued company with highly-paid managers who historically have hated the idea of a public listing, with all the disclosure requirements associated with it.

Could Blackstone actually buy Goldman? We asked a couple of investment bankers about this idea. Most thought the idea was far fetched until they took a look at the math. A private equity firm would have to pay-up some premium above the $85 billion market capitalization for Goldman. So pencil it in at $100 billion. Sounds ridiculous until you remember that a couple of private equity firms are trying to buy a Texas energy company for around half that. Maybe a private equity shop spending $100 billion to own a premier global financial institution isn’t so far-fetched.

Our bankers raised a couple of objections, however, that you’ll probably want to keep in mind.

“Where would they get the financing?” one banker asked. He pointed out that Goldman, at least, probably couldn’t finance the acquisition of itself. What’s more, other investment banks might be hesitant to leap into the financing of an acquisition aimed at making one of their fiercest competitors even fiercer.

“There’s no way Goldmans PMD’s want to work for Steve Schwarzman,” another said. And that might actually be the stake through the heart of the idea. Goldman’s partnership is probably not eager to put themselves under the control of a private equity firm. “After all,” you can imagine them thinking, “this is Goldman Sachs!”

Could Goldman Sachs be a private-equity target? [Felix Salmon]

Earlier on DealBreaker:
Unlocking Value At Goldman Sachs: Spin-Off or Transparency? [4.11.07]
Will Goldman Become the Next Public Hedge Fund? [4.4.07]

Last week we launched our Big Idea feature by proposing that Goldman Sachs spin-off its hedge fund business. Our hope was that it would start a discussion in the financial community about what direction the firm should take to increase its market value. It took a couple of days, but it looks like the discussion is underway. Today we look at two of the reactions to our Big Idea.

The first comes our way from Thorold Barker in the Financial Times. Barker starts out where we did—the observation that Goldman Sachs may be undervalued given the prices Wall Street is paying for other financial assets. “Goldman Sachs has long faced accusations of being a massive hedge fund with private equity business dressed up as an investment bank. If so, it is not being valued like one,” Barker writes.

Barker is skeptical that Goldman Sachs would take the spin-off path. Although a spin-off would allow Goldman to realize the market value of its hedge funds, Barker believes that Goldman would “not relish” giving up its lucrative hedge fund business and might not want to lose some of the strategic advantages that come with having squads of sophisticated hedge fund traders working in-house.

In our reporting since we proposed the spin-off we’ve come across another objection. People familiar with some of the top managers at Goldman do not believe the firm would have the audacity to depart so abruptly from the dominant model on Wall Street. As other banks build themselves into more complex, larger financial institutions, in part by buying up hedge funds, Goldman would be setting itself far apart from the crowd if it moved in the opposite direction. Our sources don’t think the senior management at Goldman is willing to risk the wrath of shareholders and public opinion by betting against the orthodoxy of growth.

Barker has another idea: Goldman needs to open up its hood and start showing us how its engines run, he writes.

The easiest option would be for Goldman to take the boom in alternative asset management as a sign that it is time for more transparency.

If it believes it is being short-changed on valuation it could give more detail on exactly how it generates profits in its different businesses. In that way, investors could get more comfortable with the mechanics of the group (even if that meant seeing the gut-wrenching volatility in some areas). This would also give investors a clearer view of what the sum of Goldman’s parts is really worth.

One difficulty with this idea is that it risks giving away the keys to the kingdom. Many hedge funds attempt to keep their inner-workings from the public eye for fear that exposure might invite copycats or counter-strategies from rivals. A new openness at Goldman might allow investors to better understand how Goldman makes money, but it would also allow competitors to gain this understand. The current thinking at Goldman, we’re told, is that this risk is not worth taking.

On Wall Street: The transparent alternative for Goldman [Financial Times]

[Editor’s Note: We’re launching some new regular features and “The Big Idea” is the first of them. That nifty logo you see to the left will tip you off that we’re about to engage in speculation, guess-work and commentary about the Big Idea of the day, the week or the month. This isn’t the realm of breaking news or even linking to news broken elsewhere. The inaugural Big Idea begins by asking what seems an obvious question in light of all the talk of hedge funds and private equity firms going public: What about Goldman Sachs?]

"Will a hedge fund become the next Goldman Sachs," asks Jenny Anderson in today’s super special DealBook Section of the New York Times. There are all sorts of problems with this idea, not the least of which is that while the hedge fund in question—Citadel—is growing in all sorts of new and strange ways it hardly seems to be growing into anything like a full-fledged investment bank. “Citadel has elements of an investment bank disguised as a hedge fund, minus the investment bankers,” Jenny admits. So, yeah. No. Not an investment bank. Not Goldman Sachs.

We can't help but wonder, "Could this work the other way around?" With all the talk of hedge funds and private equity going public, one story that’s been overlooked is the possibility that Goldman Sachs might spin off its hedge fund business. Goldman broke new ground when it abandoned its traditional partnership structure and let the public buy pieces of its equity at the turn of the century. But that was then, and this is now. And surely Goldman Sachs has not reached its Hegelian end-state. The end of history of the history of Goldman is a ways off yet, and the next step might be a spin-off of its profitable trading business.

That will come as a shock to some who have come to regard Goldman Sachs as a hedge fund disguised as an investment bank—but is it really so far-fetched? But the proprietary trading business—basically, Goldman trading for Goldman—has been a strong profit and growth engine for the bank, so strong that some wonder whether this piece might be far more valuable as its own entity.

Surely there are some people inside Goldman Sachs proprietary trading business wondering just how much their little corners of the investment bank might be worth if it wasn’t dragged down by the fee-gobblers in investment banking and credit groups. A free-standing GS Prop Trade would surely face some risk from facing the markets without security of Goldman’s other businesses behind it. But these guys are risk machines, and have been ratcheting up their risk tolerance for some time.

Would the rest of Goldman let the traders go? Perhaps. A spin-off might also help the other businesses at Goldman. It could refocus those parts of the firm that remain behind on their core business, and eliminate the always present suspicion that while a clients dealt with one side of Goldman the other side might very well be trading against the client’s interests.

What’s more, it would empower the investment bankers over the part of Goldman they get to keep. With the departure of Hank Paulson and the rise of Lloyd Blankfein and his trader buddies, some other parts of Goldman have been chafing. There were, of course, those old reports of the partners fighting like ferrets. Could divvying up Goldman bring peace to Broad Street?

We haven’t heard anything more than cocktail party chatter along these lines—and we’re not sure you should place all that much confidence in the opinions of the sort of people who attend the sort of cocktail parties we frequent. The recent performance of Global Alpha—down 2 percent for the year when hedge funds have had an average gain of 1.9 percent—probably isn’t exactly lighting a fire beneath the fannies of would be Prop Trading Secessionists. But, you know, it’s in the air.

And we can’t help but smile at the ironic image of Prop Trading stealing away into the night with its own spin-off at the very time when Goldman’s investment bank is out pitching so many other hedge funds and private equity firms on their own IPOs.