Rethinking The Ratings Agency Scandal, Part II: Cui Bono?

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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.

In the first place, much of this criticism is self-serving. Banks have huge losses that they need to explain to shareholders. Regulators and politicians have a public that rewards scandal mongering and is all too willing to blame Wall Street for financial and economic calamities. The ratings agencies are convenient scapegoats because much of what they do is completely obscure to the public.
There’s a vicious logic to blaming the agencies when downgrades occur. Downgrades are not prima facie evidence that original ratings were wrong. They might just as well stem from changes in available information or in financial reality. But to an outsider it can often look like shenanigans. Now that the risks of these complex credit products are obvious and causing losses, it’s all too easy to say that the high ratings were wrong. From there its an even easier leap to say that the errors of the agencies caused over-investment in the products.
But the sophisticated Wall Street banks generally did their own research on these investments. They were in at least as good a position as the ratings agency to assess the risks. And there are reasons to believe that they understood the products were riskier than the ratings might have implied. But why buy paper that is riskier than its ratings imply?
The banks had two very persuasive reasons. First, CDOs offered higher yields than similarly rated paper. (We’ll have more to say about this later today.) Second, it allowed the banks to conceal the risks on their balance sheets. Wall Street’s accounting standards seem to have treated all triple A rated paper the same, even though much of it was obviously of different credit quality. (We’ll have more to say about this, as well.) For balance sheet purposes, then, the CDO market offered Wall Street money that grew on trees—return without risk. Instant alpha.
As attorneys general and other regulators begin to set their sites on the ratings agencies, investors and journalists need to ask the ancient question: cui bono? Who benefitted from the high ratings? Who benefits from directing blame for the losses at the ratings agencies?