Friday, September 11, 2009

Curse of AAA

Chris Davis of Davis Funds sites three reasons for the collapse of AIG. (1) the financial sophistication of management, (2) the leverage of derivatives and (3) the danger of collateral requirements tied to mark-to-market accounting.

Lets talk about the third factor again. AIG was originally AAA rated. Reserve requirements to meet possible CDS losses were minimal (or possibly none) since the rating agencies thought AIG had a "strong" AAA balance sheet. When the financial system came crumbling down, the estimated losses for the swaps started going up. At this point (too late in my opinion) the rating agencies reevaluated AIG's AAA rating, and downgraded it from being AAA. They should have done this years ago when AIG's CDS exposure was going up, and not after the fact. David Einhorn at Greenlight capital calls it the Curse of AAA. Here is an extract from his May 2009 speech at IRA W. Sohn Investment Research Conference:

"Both President Obama and Chairman Bernanke have said that the problem with AIG was that greedy people put a hedge fund on top of an insurance company. As I see it, AIG failed precisely because it was not a hedge fund, but a highly regulated, AAA rated insurance company. Call it the Curse of AAA. The market incorrectly believed that regulators and rating agencies carefully monitored its risk profile and activities. As a result, AIG was able to abuse its access to unlimited cheap financing without any of its counterparties performing any additional credit analysis or demanding any collateral. Hedge funds can't abuse the system the same way, particularly in the aftermath of Long Term Capital Management, as lenders pay much more attention to hedge fund counterparty risk and collateral requirements. Had AIG been a hedge fund as President Obama and Chairman Bernanke claim, none of this could have happened.

Come to think of it, many of the spectacular failures during this crises bore AAA ratings. The Government Sponsored Enterprises (GSE), the monoline insuraners (Ambac and MBIA), AIG, and General Electric, whose slow moving train-wreck is ongoing, suffered the Curse of AAA and damaged their companies with sizable harm to the economy at large. The only AAA rated (or atleast until recently AAA) financial institution I can think of that didn't abuse its status is Berkshire Hathaway.

Investors who bought AAA rated structured products thought they were buying safety, but instead bought disaster. They can forgive themselves by blaming the rating agencies. But if the credit markets improve to the point where newly issued AAA rated bonds price with tight spreads only to later widen or ultimately fail, investors will have no one but themselves to blame. Fool me once ...

Investors have figured this out and many deny that they buy bonds based on ratings unless they are forced by law. Even Moody's largest shareholder, Warren Buffet, has said that he doesn't believe in using ratings.

We are short Moody's Investors Service. If your product is a stamp of approval where your highest rating is a curse to those who receive it, and is shunned by those who are supposed to receive it, you have problems.

Moody's says it has enormous incentive to do a good job with the ratings because the ratings are the brand. Imagine yourself the head of Moody's a decade ago. If your goal was to destroy the brand, would you have done differently?

The truth is that nobody I know buys or uses Moody's credit ratings because they believe in the brand. They use it because it is part of a government created oligopoly and, often, because they are required by the law. As a classic oligopolist, Moody's earns exceedingly high margins while paying only the needed lip service to product quality. The real value of Moody's lies in its ability to cow the authorities into preserving its status.

The ratings agencies' lobby is pushing 'reform' through modest changes to the ratings process. Why reform them when we can get rid of them? Are we waiting to blow up the Lunar economy as well? Some wonder what would happen without government sanctioned ratings. It is hard to imagine how things would be any worse.

Even if ratings were free of conflict, the unfixable issue is that the rating system is inherently pro-cyclical and economically destabilizing. When times are good, rating upgrades reduce borrowing costs and contribute to credit bubbltes. The more debt they rate, the more profit they earn. When times are bad, rating downgrades accelerate a negative feedback loop and can be catastophic for entities that rely so much on their credit rating that a rating downgrade jeopardizes their existence. The monoline insureres (Ambac and MBIA) and AIG suffered this fate. This empowers the rating agencies to decide whether a company lives or dies. The rating agencies are sensitive to this responsibility. As a result, they fail to use the downgrade as a warning signal to investors, and when they finally do act, it is often coup de grace.

Regulators can improve the stability of the financial system by eleminating the formal credit rating system.

Credit analysts don't believe in credit ratins; equity analysts do. Moody's share trade at 19x estimated earnings that, wink-wink, they are supposed to beat. Ironically, for a firm that evaluates credit, its balance sheet is upside down, with a negative net worth of $900 million.

That is a lot to pay for a franchise with a socially undesirable product and a shattered brand that exists at a time when the government is considering broad reform in its mission to fix some of the systemic regulatory issues that got our economy into trouble in the first place."

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