Debt rating agencies – worse than short sellers for corrupting markets!

Experience teaches you that dramatic initiatives to remedy errors (reactive) occur long after they can have any effect. Also one learns that the enthusiasm to impose remedies causes massive inefficiencies.

The problem is that the imposition of new ‘preventative’ measures presumes some understanding about the causes – which is usually bunk. For example, there’s currently an outbreak in a few Canadian hospitals of C. difficile -a nasty bug that produces toxins causing bowel issues after antibiotics have killed your good bowel bacteria – it’s not the first outbreak by a long shot, so if the cause was really understood in the first place then in theory measures already in place should have prevented any recurrence no???

Rating agencies are notorious for after-the-fact downgrades. I’m getting more forgetful as the years pass, but one instance of this pops to mind. I was working at an institutional money management firm, and our bond guys held some First Canadian Place bonds. The building (collateral) is pictured here, and I dug up this quote relating to the episode. The context of the quote was how difficult it can be to value illiquid (market no longer exists, due to a default) assets in mutual and other funds:

“A good example would be the First Canadian Place office building in Toronto. At the time of the issue of bonds secured by this building in 1988, it was appraised at nearly $1 billion. A few years later, after the collapse of the Reichman’s Olympia & York real estate company in the early 1990s, the same building was appraised at $400 million. The building had not changed; however, sentiment about the commercial real estate market had changed.”

I had to laugh – you older folks will no doubt remember that “sentiment about the commercial real estate market had changed” at that time is about as comic an understatement as you can imagine. These bonds were rated “AA” when issued, and hung onto that rating pretty much until they turned into junk.

After the world began to fully appreciate the extent of the mess a number of European countries are in, and at least partially comprehend how that mess can become viral (like c. difficile) and infect others, it’s time to downgrade (yes, I’m being sarcastic) their bonds so their ability to pay can (higher interest rates) be thoroughly damaged.

Bloomberg today: “The euro slipped to a one-week low against the dollar as concern that Greece may become the currency region’s first default outweighed the European Central Bank’s interest-rate increase. The 17-member currency weakened as investors considered whether ECB President Jean-Claude Trichet will comment on the central bank’s acceptance of Greek debt as loan collateral in the event of a default when he briefs the press from 2:30 p.m. in Frankfurt. The 25 basis-point rate increase to 1.5 percent was predicted by all 55 economists surveyed by Bloomberg.”

I wonder if I can get my bank to accept my mortgage as collateral for a loan to buy a new Harley? But I digress. There’s an incomprehensible pattern that’s evolved over the decades. For instance, I just had a fine fellow in my office who used to work for a Canadian bank. He told the tale of how he was forced to fire some banking clients that were generating $8 million in revenues (admittedly a small but secure source of funds) during the financial crisis (2008 – 2009) years. For some unfathomable reason, risk managers (a profession growing by quantum leaps – Ayn Rand, the author of Atlas Shrugged, must be turning in her grave) figured it was wise to call the loans of good customers to offset the huge losses generated by their trading and ‘structured finance’ operations.

I myself was managing a number of limited partnerships invested in tiny exploration companies – the portfolios were collateral for loans (fully marketable securities but battered by the market) and the value of the assets held covered the loan obligations several times over (i.e. no risk). Nevertheless, the bank forced this portfolio manager to sell securities at rock bottom prices, seemingly improving the collateral coverage but WAIT – I had to sell the good ones (I could get a bid for the better stocks in a very thin market) so the quality and true value of their collateral was deteriorating with every sale. If they’d left well enough alone (the LP’s were making the payments after all) or even better – let us ‘use’ the loan facility that was in place to borrow and “buy” cheapened securities from other distressed investors, then everyone would have made lots more money (investors profit, more fees for us and more business for the bank in the long run).. Funny – the banker asked my associate (trader) and I “You wouldn’t really buy more of these stocks if you could would you? The market can never recover!”. I think we frightened him when both of us nearly jumped out of our suits shouting in unison “Heck yes we would. In all our other funds we ARE buying!”  FYI – the market recovered and we all (especially investors) would have made out like bandits if indeed we bought instead of sold……..but the banker was just doing his job and was subsequently promoted.

Common sense suggests that the ECB should use debt as ‘collateral’ since making matters worse for struggling countries will only make matters worse for the healthy ones. And a rate hike is the opposite of what the doctor ordered. But then, nowadays there’s nothing less common than common sense is there?

And rating agencies should be used a gauge by bond holders – but in a “do-the-opposite” fashion. The lower the rating the more likely holding the bonds will make money. Unfortunately, the ‘risk managers’ will not allow investment managers to own anything but the best rated paper, doomed to become junk over the hold period. So there is the rub. Much – not all of course – struggling borrowers when their bonds are borderline junk (according to rating agencies) should get investor money – they will stop struggling, the ratings will improve (much too late as always) and bingo life is grand. But NO!!! What really happens?

The monster we’ve named ‘compliance’ – which is a more official term meaning ‘panic-induced preventative measures that will cost plenty and prevent nothing at all’ – won’t allow investors to buy undervalued money-making (and life-giving) securities UNTIL they get top rated. Then the issuer is bombarded with unneeded funds just prior to the next meltdown; they spend the hoards of new money on stupid initiatives (who wouldn’t take the money?), then borrow even more to spend on silly projects (takeovers) and investors watch their bonds and stocks turn to junk – at the end of the roller coaster ride the rating agencies downgrade these same investments.

Risk managers now (compliance you know) require the newly downgraded securities be sold losing investors (people, pension funds, endowments, your bank) a fortune. Preventative measures – like short sellers – cause even more risk, volatility and inefficient (losses for good capitalists, profits for sleazy ones) distribution of wealth globally.

Click on this text to link to article about recent CFA Survey: Credit agencies lack credibility after role in crisis: survey

Invest to Live, Live to Ride

About Mal Spooner

Malvin Spooner is a veteran money manager, former CEO of award-winning investment fund management boutique he founded. He authored A Maverick Investor's Guidebook which blends his experience touring across the heartland in the United States with valuable investing tips and stories. He has been quoted and published for many years in business journals, newspapers and has been featured on many television programs over his career. An avid motorcycle enthusiast, and known across Canada as a part-time musician performing rock ‘n’ roll for charity, Mal is known for his candour and non-traditional (‘maverick’) thinking when discussing financial markets. His previous book published by Insomniac Press — Resources Rock: How to Invest in the Next Global Boom in Natural Resources which he authored with Pamela Clark — predicted the resources boom back in early 2004.
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