THE BLOG
02/20/2013 01:28 pm ET | Updated Apr 22, 2013

The S&P Lawsuit Shouldn't Leave Investors Feeling Too Moody

If I were a Moody's executive, I'd be feeling pretty aggrieved with fellow credit rating agency Standard and Poor's right now. Thanks to the U.S government filing an unprecedented $5 billion law suit against S&P on Monday, not only have shares in S&P owners McGraw-Hill tumbled, but Moody's has also had around 18% wiped off its share value in just two days.

In the great blame game that followed the financial crisis, both ratings agencies found themselves right in the firing line. Rightly, too, given the spectacular collapse of millions of dollars worth of collateralized debt obligations that were downgraded only after significant delays by the likes of S&P.

Since they received such ignominious attention in 2008, ratings agencies have tended to keep a lower profile. Media coverage is mostly confined to their decisions on government rather than consumer debt, decisions which are made relatively infrequently. Whether their behavior was the result of a hedonistic bubble chase or a more innocent lack of foresight is still debated by some, but with any luck further investigation during S&P's trial should help clear up the blatant obfuscation of what it is that ratings agencies actually do on a daily basis.

Crucially, animosity towards ratings agencies has resulted in the widespread distrust of their predictive capacities on the part of many in the world of finance. At best, many investors now see the ratings given by S&P et al. as meaningless posturing, and at worst as complete untruths.

If, as a result of further probing in the U.S. government's case, S&P ratings are indeed found to be misleading or deficient in some way, this may actually spell good news for markets. Investors who distrust the advice they receive from them will now have greater courage in their contrary convictions, freeing them to make better-informed decisions; decisions which lie outside the bounds of credit scores that can appear arbitrary for certain products.

If you still consider S&P et al. to be the imperious masters of financial information, however, the fact that many now disregard their advice based on negative press should be cause for concern. The market ignores credit scores at its peril and disavowing these relevant signals is a sure fire road to ruin. A downgrade, for instance, could now be ignored more readily by moneymen who think they know better than the experts at the agency, resulting in increasingly large bets on risky, erratic products.

Yet the fact remains that S&P, just like any other credit rating agency, is not omniscient as this theory suggests. They can make fallible judgments just as easily as a hedge fund or private equity firm can.

The only difference is that markets and investors are still well ahead of the game the ratings agencies play, and they are certainly miles ahead of us news hawks. If you personally have hundreds of thousands at stake in a trade, you're going to make it your business to hunt down every last scrap of relevant data. And you're going to make damn sure that you understand every last detail of the products involved, including the potential downside risk.

The wisdom of the market has actually been evidenced through this whole affair. Shares in McGraw-Hill started diving well ahead of the official filing of legal proceedings against the company late on Monday. Overall, shares in McGraw-Hill dropped 13.8% on the day. By Tuesday, the decline had already slowed, peaking at only 8.9%.

It may not be a view that has reached consensus yet, but there is a certain acceptance of the idea that we tend to overplay the impact of announcements made by ratings agencies in any case. In August 2011, the very same S&P now being sued downgraded the U.S federal credit rating. Ironically, the economic position of the U.S has actually improved since then. Bond yields remain stable at low levels. We did not see a flock of moneymen pulling their American investments, something many had predicted should a downgrade occur.

Maybe there was a time the estimates of the major raters mattered. Maybe this power was misappropriated during the financial crisis. But, by slapping a $5 billion lawsuit on S&P, the American government is sending a dangerous signal that may turn into a self-fulfilling prophecy: that we are still at the mercy of a handful of credit assessment firms.

Those in the know won't buy this, nor will they be fazed if S&P or any of the other raters are found guilty. It may appease popular loathing, drawing on public disgust at the rampant self-interest that still dominates world finance, but there are bigger financial fish to fry. Legally attacking financial institutions for their previous misdemeanors is all well and good, but regulators need also to get a grip on the here and now to break the cycle of political gesturing over action that dominates the modern financial agenda.