Greenlight: Shorting Moody's Was A Good Idea

I'd like to thank the good folks at Dealbreaker for bringing to my attention a "Dear Partner" letter from Greenlight Capital, reviewing the unlamented but departed second quarter of 2010.

Greenlight has made some gains for its investors, though they are as the letter acknowledges far from spectacular. There are three partnerships involved, and the year-to-date returns on the three are 1.6 %, 2.2%, and 0.8%.

Greenlight professes to have "no idea" what will happen in the economy in the second half, and to be maintaining "a conservative and defensive portfolio, with a small net long position throughout."

What were their two best plays during the second quarter? They own some gold, and it has appreciated nicely. That's first. The second, and only other "significant" winner, was a short position on Moody's Investors Service (MCO).

Moody's took a hit, the letter explains, because the "proposed financial reform bill raises the rating agency legal liability more than the bulls expected." Of course, the bill itself didn't pass in time for the effects of its passage to be felt in the second quarter numbers. So, filling in the blanks a bit ... we can infer that as the likelihood of passage of the Moody's-impairing provisions became obvious, the stock price fell in anticipation of the legislation, and Greenlight locked in its profit from this short position during the quarter.

I've included a one-year stock chart of Moody's. The stock's price has hit its recent peak near the end of the first quarter. It was $30.26 on March 22. It went on a long slide at that point, bottoming out at $18.89 on May 31. So, yes, shorting was a good idea.

As it happens, it is the courts that decide what does or doesn't violate the first amendment, not the Congress. So insofar as the amendment has provided Moodys with a defense in the past, it might continue to do so. In that case, we may someday judge that the market over-corrected.

"Buy on the rumor, sell on the fact" -- may in this case translate, "sell on the threatened legislation, buy on its passage."

Usual disclaimer: THIS IS NOT INVESTMENT ADVICE! Don't buy or sell any damned thing because any blogger says so. Emphatically including me.

Still, Moody's may have an intriguing future.

Credit Agencies Roundtable

The SEC held its roundtable last week, in four panels, "To Examine Oversight of Credit Rating Agencies."

If you missed it, you might be wondering, what did the much maligned "big three" agencies: Moody's, S&P, and Fitch, have to say for themselves? Was it just, "yes, we gave AAA ratings to securities that might have been structured by cows, but it was all first amendment protected, nyah nyah"?

Well ... not quite. (Though you can get your fill of the first amendment issue in a page C1 story of the Wall Street Journal this morning.)

Here, I'll try to give you the money quote from the statement of each of the Big Three's reps at this roundtable.

From Fitch came Stephen W. Joynt, who said: "Finding the right balance in assigning ratings of major global financial institutions during the current global financial crisis has proved challenging." He then made the point that Fitch built into its ratings the assumption that the US government wouldn't let the largest of these institutions fail. When it did let Lehman Brothers fail, all bets were off.

Or, in Joynt's words: "we have generally assumed that government support would be
forthcoming for financial institutions in peril, and it has been. Lehman Brothers was a notable exception; like most market participants we expected a ‘government engineered’ solution that did not materialize."

Raymond McDaniel, the CEO of Moody's Investors Service, defended the issuer-pays model that each of the Big Three uses. For the most part, he says, issuer-pays works better than the preceding regime of investor-pays did (or, by implication, than the later would if instituted again).

And from S&P there was Deven Sharma, who said in essence that people shouyld stop second-guessing them with hindsight. They're doing an essential job and doing it well, by gum.

Well, okay, he was a bit more eloquent: "Accountability standards that allowed for second-guessing of judgments made in good faith could have the unintended consequences of compromising the independence of those judgments (to prevent against fear of later criticism) and hindering analytical innovation, both of which would be harmful to the markets as a whole. Accordingly, we strongly believe that any accountability measures should focus on an [the agency's] adherence to its policies and procedures, not on second-guessing ratings judgments through regulatory action or private litigation."

Actually, the most coherent defense of the big three at the roundtable came from a representative of the AFL-CIO sitting in on the "competition" panel. He asked his listeners first to consider why the agencies are valuable.

The “cost of investing in fixed income markets” would go up significantly, especially for small investors, if the raters should vanish, and a money market manager’s role would become much like that of a hedge fund manager; his services would no longer be “a commodity” and become much more “high value added.” That would be good for the money market managers, but bad news for retail investors.

“Given all that,” he said, he is not an enthusiast of competition in the credit rating field, because should “full competition” be encouraged “the equivalents of Madoff’s accountant …will step in.” Here he was making a reference Friehling & Horowitz, CPAs, P.C., the small auditing shop that is alleged to have participated in Bernard Madoff’s Ponzi scheme by only purporting to conduct the appropriate audits.

Intriguing point, which also ties into network effects, economies of scale, etc.

Credit Agencies Roundtable

The SEC will hold a roundtable on credit rating agencies one week from Wednesday, April 15, at 10 AM, at the agency's DC headquarters.

Here are the particulars.

10:10 a.m. — Panel One: Current NRSRO Perspectives: What Went Wrong and What Corrective Steps Is the Industry Taking?

Panelists:

Daniel Curry, DBRS
Sean Egan, Egan-Jones Ratings
Stephen Joynt, Fitch Ratings
Raymond McDaniel, Moody's Investor Service
Deven Sharma, Standard & Poor's

11:30 a.m. — Panel Two: Competition Issues: What are Current Barriers to Entering the Credit Rating Agency Industry?

Panelists:

Ethan Berman, RiskMetrics Group
James H. Gellert, RapidRatings
George Miller, American Securitization Forum
Frank Partnoy, University of San Diego
Alex Pollock, American Enterprise Institute
Damon Silvers, AFL-CIO
Lawrence J. White, New York University

12:30 p.m. — Lunch Break

1:15 p.m. — Panel Three: Users' Perspectives

Panelists

Deborah A. Cunningham, Securities Industry and Financial Markets Association
Alan J. Fohrer, Southern California Edison
Christopher Gootkind, Wellington Management
James Kaitz, Association of Financial Professionals
Kurt N. Schacht, CFA Institute
Bruce Stern, Association of Financial Guaranty Insurers
Paul Schott Stevens, Investment Company Institute

2:45 p.m. — Panel Four: Approaches to Improve Credit Rating Agency Oversight

Panelists

Richard Baker, Managed Funds Association
Jörgen Holmquist, European Commission
Mayree C. Clark, Aetos Capital
Joseph A. Grundfest, Stanford Law School
Glenn Reynolds, CreditSights
Stephen Thieke, Group of Thirty

The roundtable is expected to end at approximately 4:15 p.m. with concluding remarks by Erik R. Sirri, Director of the SEC's Division of Trading & Markets.

The New York Times

A front page story in today's New York Times, by Stephen Labaton, onthe basis of "recent interviews with officials" and statements at the incoming crowd's confirmation hearings, tells us that the new administration will "move quickly to tighten the nation's financial regulatory system."

Both Mary Schapiro and Timothy Geithner -- the new heads of the SEC and the Treasury Department respectively -- say for example that they want to change the compensation model of credit rating agencies.

I'll link you to what I said about this issue in October in my other blog. If you don't feel like chasing that link, here's an incentive. Cows are involved.

But if even that incentive leaves you unmoved, here's the crucial (non-bovine) paragraph:

There is a powerful case to be made that the credit rating agencies have had an inherently conflict-prone business model, and that this has introduced an element of instability into the US financial system in recent years. In short, they're paid by the issuers they rate. If they rate an issuer's garbage AAA, that issuer will presumably give them repeat business. If they downgrade, the issuer has had the option of shopping around for a higher rating elsewhere. So there's been a race to the bottom, and anyone can get a AAA.

My own instinct, when faced with a perverse incentive structure of that sort, is to ask not "how soon can we get the government to prohibit this?" but raher, "what has the government done to encourage/empower this?"

In ther case of the CRAs and their compensation model, there are good answers to the latter question. But I don't like to become too predictable, so I won't pursue that. Consider it your homework assignment, dear reader.

Instead, I'd just like to point out in a cynical spirit that S&P and Moody's could strike back were they to feel really threatened by any regulatory change. They could lower the credit rating of US Treasury bonds. How devastating would that be to the ability of the US to keep borrowing on a world-historically absurd scale.

Mutual assured destruction. Just like the old Cold War.