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Rethinking The Ratings Agency Scandal, Part III: Evidence Of Error Discount Pricing

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.