Why I am short the Ratings Agencies

I am on record here on this blog and on StockTwits TV as having the opinion that the three agencies primarily responsible for putting ratings on mortgage backed securities are among the most responsible entities for the economic crisis the nation and indeed the world has endured these last 20 months or so. But feeling these corporations are criminally and civilly culpable does not necessarily warrant taking a short position in their stocks.

For those who may be unfamiliar with the agencies I am referring to, they are Moody’s, S&P, and Fitch. They place ratings on investment vehicles of many types and their ratings are used by Institutions, Governments, and Private Investors to judge the risk level associated with these vehicles. In many cases government entities and institutions are required by their charters to invest only in vehicles of a certain rating or higher. This is to ensure that they do not take on unacceptable levels of risk in their investments. If you are a private investor interested in buying corporate or government bonds you will be presented by your broker with a rating as more than likely the first criteria mentioned, and if you use an online brokerage the first thing you’ll see on your bond screening tool is likely to be ratings screen.

For the sake of this topic it is important to know that of the three only two are traded in the United States, Fitch is a subsidiary of Fimilac and trades on the Paris Euronext exchange. Since I trade predominantly here in the U.S. I will not be referring to Fimilac and will not be taking a position in it.

The other two are not in and of themselves traded directly, they are subsidiary companies, and it is their respective parent companies in which I hold short positions. Moody’s Investors Services is a subsidiary of Moody’s Corp and trades on the NYSE under the ticker MCO, and S&P is a subsidiary of McGraw Hill and trades on the NYSE under the ticker MHP.

The Case for the Short Position

1) It has been nothing short of shocking to me that these agencies have been subject to very little attention from the Government or the Main Stream Media however this appears to be changing. Articles in Bloomberg, and the Wall St. Journal (WSJ) lately have begun to notice that these agencies have escaped notice, and are apparently unchanged and unrepentant regarding their role in the crisis. In a piece in the WSJ on 16 Sept, 2009 they quote Frank Portnoy, a University of San Diego law professor and former Morgan Stanley banker, as saying the following in regard to the rules some investors must follow when buying rated securities: “What happens as a result of these rules is that investors have to buy securities that have particular ratings, It creates this incredible dysfunctionality where the ratings agencies, instead of surviving based on their ability to generate good ratings, are basically selling licenses” to the capital markets.

2) Governmental entities on the state and national level are beginning to ask questions and I believe this will gather momentum until they are called upon to answer for their roles in courts of law or houses of government. Even if this does not result in criminal or civil penalties it will put pressure on the stock price.

Senate Banking Committee Chairman Christopher Dodd, has said the companies wrongly assigned top credit rankings to subprime-mortgage bonds just before that market collapsed in 2007. House Financial Services Committee Chairman Barney Frank this week said he wants to cut references to credit ratings from U.S. rules because the provisions foster reliance on ratings and deter investors from doing research.

California Attorney General Edmund “Jerry” Brown Jr. launched an investigation Thursday into the largest ratings agencies to see if they broke state laws by slapping top ratings on toxic mortgage securities during the credit boom.

Even if ones own political slant is antithetical to Mr. Dodd, Mr. Frank or Mr. Brown it must be admitted that they are unlikely to just stop their investigations or let these agencies off the hook easily, and they are very good at getting the ear of the press.

3) The securities industry regulating bodies such as the SEC and FDIC are beginning to make statements indicating possible policy changes with regard to the ratings agencies.

Here are some of the comments made by the SEC through it’s chairperson or as quoted by the WSJ, Barrons, MarketWatch, or Bloomberg:

“Credit agencies will have to disclose more of their ratings history, and banks will have to share data used to rate financial products with all credit agencies, under rules adopted by U.S. regulators on Thursday.”

“The agency also voted to ask for comment on whether credit agencies should be categorized as “experts” under securities law, and thus subject to tougher standards of liability. The SEC said it is not proposing such a move yet, but wants feedback on its potential impact.”

“Further, the SEC proposed on Thursday to require banks to disclose all preliminary ratings they receive from credit agencies in an attempt to stop banks from shopping for the best credit rating.”

The Thursday in the quotes was this past thursday, 17 Sept. Also discussed at that meeting were changes that may make it easier for investors to sue credit raters and require the companies to disclose revenue from their biggest clients. This would have the effect of putting a chill on the agencies desire to rate certain paper, and nullifying to some degree the benefit to the clients these ratings provide. Both of these are a down force to the stock price in my opinion.

The Case against the Short Position

1) The main case that can be made against the position arises from the aforementioned fact that the ratings agencies are subsidiaries of larger entities and only represent a certain percentage of their overall business.

2) The ratings agencies themselves continue to be profitable due to the requirements of so many investing entities to use the ratings. Even if pressure is put on from all fronts no real alternative exists in a form that could supplant the big three that wouldn’t present the same service model.

3) Both of these companies has very strong international exposure and their product is used in many countries other than the United States and this geographical diversification provides a stabilizing force.

4) The SEC and the government act very slowly and any changes or actions take so long to come to fruition that these companies may have time to make the necessary changes to comply, and since they have the infrastructure and relationships already in place maintain their dominance in the market.

Justifications for taking the short positions at this time

I feel the potential for actions against the ratings agencies that will cause a down force on the parent companies stockprice far outweigh any positives that will arise from that segment of their overall business. Even with the lack of scrutiny on the ratings agencies the parent companies have underperformed the market and I do not feel they will be able to increase their organic growth going forward, in fact I am dubious as to their ability to sustain the level they have had in the short to medium term. As more and more outlets for financial information come online the core business of both these companies will endure increasing competition for the market.

As the pressure to change the current paradigm mounts, the ratings agencies may be forced to change, or may be relegated to lower levels of relevance. Even if they remain profitable I do not see the opportunity for growth, and see the potential for an entity not challenged by the conflicts of interest they have, or are perceived to have, coming in and taking market share from them.
In the event the SEC rules in a manner that will allow investors to sue the ratings agencies, they will come under a veritable assault from all sides as investors of all sizes come after them to recover the losses they have incurred. Even the threat of such ruling is enough in my opinion to justify the short position.

Disclaimer:
I hold short positions in both MCO and MHP at the time this blog is written. I may exit part or all of the position at any time. This is not a recommendation to buy or sell any security. It’s your money and you should do your own research before taking on any position.

References:
http://www.marketwatch.com/story/calif-attorney-general-starts-rating-agency-probe-2009-09-17
http://www.bloomberg.com/apps/news?pid=20601087&sid=aoPhRiCJNVe4
http://online.wsj.com/article/SB125321591774420585.html?mod=wsjcrmain

My Blog on Ratings

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