Is The Ratings Agency Scandal Overwrought?

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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.

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