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Friday, October 28, 2011

What Value the Rating?

I often ask myself how valuable any sell-side research can be, given the obvious conflicts being suffered through by a banks’ research team. The attributes that undermine the effectiveness of a banks’ research analysis are numerous – here are some:

1. the bank typically has many more buy recommendations than sell recommendations (The Big Short’s Vincent "Vinny" Daniel neatly captures the conflict when he says “You can be positive and wrong on the sell side,”… “[but] if you’re negative and wrong you get fired.”)

2. similar to the prior point, the uneven distribution of ratings renders the “buy” rating less meaningful

3. the accuracy of a rating isn’t easy to test, as its term and range isn’t always well-defined

4. the rating changes with regularity, and so never adjusts or converges to a final number, so the same analyst may appear right then wrong then right again. Were they right, overall? (see for example “S&P upgrades Google stock days after "sell" view”)


I remember chatting, a while back, to a former sell-side research analyst from a so-called Yankee Bank about what it was like rating stocks during the heat of the financial downturn (2007-2008).

He commented on the futility of his position: his predictions may just as easily be right as wrong, given the heavy influence of emotions, or market technicals, rather than any reliance on company fundamentals – which he was being asked to judge.

But he also described his position as awkward: in a market in which he truly expected almost everything to keep going down, he wasn't in a position to issue sell ratings on all his stocks. Why maintain a buy rating, or a hold, if you really think the client out to sell? But what effect would be produced if you put a sell rating on everything? Putting a sell rating is bad for business, and by way of the influence banks wield in providing ratings, serves only to increase the likelihood of a further decline, or to exacerbate that decline.

So in a down market, we have an influential bank analyst, who otherwise provides useful market color, feeling his position to be both awkward and futile.

I remember his remarks from time to time, especially when people ask me what I think of the US downgrade by S&P or the downgrading of other sovereigns like Italy or Spain.

While the downgrade may or may not be the right action, from a legal perspective based on the code of NRSRO ratings, one has to wonder what the benefit may be. If the downgrade action reflects the rater's perception that a sovereign entity may struggle to raise funds – as was the case in the Italy downgrade action – the actual downgrade itself only serves to heighten the sovereignty's difficulties in raising such funds. Economists often call this a self-fulfilling prophecy or a self-effectuating phenomenon.

As opposed to the threat of downgrade hanging like Damocles' sword above a finance minister, encouraging him/her to get the country's finances in order, the downgrade action serves little purpose - only making it harder to get one's finances in order.

And thus the duality of the position: can one credibly support an action that only serves to exacerbate a difficult situation, while helping nobody (aside, perhaps, from short sellers and political opponents to controlling regimes or parties).

The bank analyst felt his position to be futile and awkward. The rating analyst may struggle to sleep: his or her option is to defy the company's code, or to be destructive.

Monday, October 10, 2011

Will S&P's Wells Notice Change Their Behavior?

The role of the credit rating agencies in the recent financial crisis has been highlighted by numerous investigations including the Financial Crisis Commission and the Senate Permanent Subcommittee on Investigations (PSI). It therefore comes as no surprise that Standard & Poor’s receipt of a Wells Notice, indicating the SEC’s intention to sue, has garnered its fair share of attention. Challenges presented by the issuance of the so-called Wells Notice, and the circumstances surrounding it, will likely culminate in rating agencies and issuing entities having to adjust their approaches to the ratings process.

The various forms of media speculation have focused on Delphinus CDO, a crisis-era structure backed by subprime mortgage bonds, as the focal point of the SEC’s investigation. This transaction was highlighted by Senator Levin’s PSI report as a “striking example” of how banks and ratings firms branded mortgage-linked products safe even as the housing market worsened in 2007.

The implications of S&P’s internal emails, made public through the Senate’s investigative process, are that the rater may have known, at the time it was issuing its ratings on Delphinus, that the ratings being provided were inconsistent with its then-current methodology. In essence, S&P’s model and ratings were contingent on certain preliminary information made available to them by the underwriting bank. When that information changed at a late stage of the deal’s construction, S&P’s model was no longer able to produce results consistent with the desired rating.

That S&P nevertheless issued the originally-requested rating, despite its being incompatible with the new information, opens a line of questioning into whether S&P’s ultimate rating adequately reflected its own analysis. In issuing the Wells Notice, the SEC may at this juncture reasonably suspect S&P of committing a Rule 10b-5 violation.

The SEC would be pressed to show that S&P knew, at the time it was providing the rating, that the rating was ill-deserved (and thus misleading to investors). If the SEC is able to show that S&P intentionally provided a misleading rating, they would distinguish this case from several of the other rating agency complaints that have been dismissed.

Importantly, the SEC’s case would almost certainly survive the rating agency’s preferred defense motion that invokes their First Amendment rights to express an opinion. Floyd Abrams, S&P’s external counsel on First Amendment issues, himself confesses in his September 2009 testimony before the House that “[the] First Amendment provides no defense against sufficiently pled allegations that a rating agency intentionally misled or defrauded investors,” … “nor does it protect a rating agency if it issues a rating that does not reflect its actual opinion.” (emphasis added)

Aside from the abovementioned Wells Notice, the SEC is showing a keen focus on each rater’s application of its own public methodology: their annual rating agency examination report, released late last week, cites as an “essential finding” that “[one] of the larger NRSROs reported that it had failed to follow its methodology for rating certain asset-backed securities.”

The result of the Delphinus investigation notwithstanding, the mere threat of legal action alters a rater’s approach to issuing ratings and maintaining current ratings. We have already seen the fruits borne of pressure instilled by the new regulatory landscape. In late July of this year, S&P stunned the market by pulling away from rating a commercial mortgage-backed securities (CMBS) transaction, led by Goldman Sachs and Citigroup, on the evening prior to the deal’s closing. S&P reportedly needed to adjust its model to reflect “multiple technical changes,” ultimately leading to the deal being shelved.

The manner in which S&P dealt with a controversial and costly methodological change suggests a new-found sensitivity towards violating the 10b-5 legal standard. Such a drastic action, bringing significant embarrassment to S&P in addition to the loss of market share, would have been inconceivable in the prior, revenue-centric, competitive landscape.

With raters seeking at all costs to avoid a 10b-5 violation, we foresee them increasingly turning away bankers who pressure them with “last-minute” demands. Bankers, risking their deals falling through, will be driven to accommodate the rater’s requirements in providing their supporting data in a more timely fashion, well in advance of a deal’s closing. Perhaps we’ll have fewer deals done as a result; but perhaps those deals will be safer, supported by less-hurried analyses.

As we have seen before, it continues to be legal risk, and not reputational risk, that has encouraged oligopolistic rating agencies to re-focus their attentions on the quality of the product being provided. With Damocles’ sword swinging over-head, we can only hope for more objective ratings going forward – and fewer stale ones.