So maybe trouble at Lehman Brothers isn't just short-sellers spinning a web of financial panic after all. Standard & Poor's cut the ratings of Lehman Brothers, as well as Merrill Lynch and Morgan Stanley today. Counterparty credit ratings, which have been getting a lot of attention lately, were one prong of the S&P credit analyst Tanya Azarchs critique of the banks. The weakness of investment banking business--IPOs off 70% and M&A down 40%, according to some estimates--and the potential for more write-offs didn't help either.

Azarchs is also criticizing the brokerages' much vaunted capital raising. A good portion of the money raised by the firms has been in so-called hybrid securities that combine equity and debt aspects. The ratings agencies are wary of these because certain debt-like covenants and payment obligations can impose increased cash flow stress on banks.

The stock prices have taking a beating and the credit-default swap spreads are getting wider.

The larger commercial banks also didn't escape S&P's negativity on the financial sector.

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.

"Too little. Too late."

That’s how New York Attorney General Andrew Cuomo described the reforms proposed by Standard & Poor's and Moody's Investors Service in the wake of the subprime debt ratings catastrophe. Both S&P and Moody’s have recently announced plans to strengthen their ratings system in an attempt to restore their credibility and fend off regulatory or legislative action. But these proposals—which include rating have been met with skepticism and mockery. (More mockery here.) Cuomo referred to them as “supposed reforms.”

“Both S&P and Moody's are attempting to make piece-meal changes that seem more like public relations window dressing than systemic reform,'' Cuomo said in a statement about his investigation into the ratings agency.

Cuomo didn't describe exactly what actions his office is planning on taking, but according to Charlie Gasparino and the Wall Street Journal he is considering employing the Martin Act to go after wrong-doing in the mortgage meltdown. This is the breathtakingly powerful state securities law that grants the Attorney General broad investigatory and prosecutorial powers. It lay nearly dormant for three-quarters of a century after it was passed. The Martin Act was used to go after smaller boiler room type operations but never against the big Wall Street firms. At least, not until Eliot Spitzer discovered the law and used it to tear into Merrill Lynch. After that, Spitzer rampaged across Wall Street wielding the Martin Act to force enormous settlements from a dozen or so firms.

Why is the Martin Act such a big deal? A 2004 Legal Affairs article by Nicholas Thompson describes the terrifying power of the AG under the law:

To win a case, the AG doesn't have to prove that the defendant intended to defraud anyone, that a transaction took place, or that anyone actually was defrauded. Plus, when the prosecution is over, trial lawyers can gain access to the hoards of documents that the act has churned up and use them as the basis for civil suits. "It's the legal equivalent of a weapon of mass destruction," said a lawyer at a major New York firm who represents defendants in Martin Act cases (and who didn't want his name used because he feared retribution by Spitzer). "The damage that can be done under the statute is unlimited."

Interestingly, Spitzer first hatched the plan to use the Martin Act against Wall Street after a meeting with a securities lawyer named Eric Dinallo—the same guy who has been attempting to strong arm Wall Street into bailing out Ambac.

Cuomo Says S&P, Moody's Reforms Won't Stop His Probe [Bloomberg]