Shares of McGraw-Hill Co. (MHP) and Moody's (NYSE:MCO) have sold-off dramatically this week following news that the Department of Justice and several state prosecutors were expected to file suit against MHP's Standard & Poor's rating agency unit. According to a Bloomberg report the US Justice Department filed their civil complaint in Los Angeles Monday evening.
The suit alleges that McGraw-Hill and S&P inflated the credit ratings of RMBS' and CDO's between the years 2004-2007. This is the first federal case against a ratings company for "grades" related to the credit crisis. Federal prosecutors allege that S&P downplayed the risks on portions of the securitized tranches as a means to get more business from the investment banks issuing the securities.
In this article we will attempt to provide an overview of a big picture and assess the potential risks and possible investment opportunities for both companies.
Unintended Consequence and the Blame Game: To many folks, the credit rating agencies (CRAs) remain primary suspects with their involvement in the financial and credit market meltdown. Each of the big-three rating firms (S&P, Moody's and Fitch) blessed collateralized debt obligations (CDOs) with AAA ratings. Of course, these coveted investment grade ratings were issued prior to the mortgage crisis.
Ultimately, the credit rating firms were dead-wrong on their opinions of these mortgage-backed structured products. However, lawmakers, regulators and everybody else were wrong too! An excellent overview of the interactions between lenders, GSE's (Freddie Mac, Fannie Mae), HUD and the credit rating firms are chronicled here .
Complex Transactions: The bane of CDO markets might best be described as the derivation of Wall Street "wizardry" gone wrong. Asset-backed securities (ABS) have been around for years and the premise was originally simple. Pool tranches of assets with similar or stable cash-flows (such as a mortgage), bundle them up and sell them to investors.
In theory, this would help to strengthen the lenders balance sheet while the investor would receive a coupon on the securitized packages. The economic benefit is viable providing that the "collateralized" assets retain their notional or expected values and continue to generate cash-flows.
One aspect to the problems leading up to the credit crisis was the tremendous volume and dollar amount of CDO and RMBS securitization tranches being issued (see chart below). Also, many of the CDO bundles issued contained a diverse range of credit-quality loans. With trillions of dollars of variable credit-quality synthetic instruments pumped into the capital markets, it is conceivable the rating firms may not have fully realized the potential for error(s) in their evaluations.
It also likely did not help matters that the Gramm-Leach-Bliley Act (aka Financial Services Modernization Act of 1999) repealed parts of the Glass-Steagall Act of 1933, which had prohibited business combinations between investment banks, commercial banks and insurance companies.
Enter Credit Rating Agencies: With the advent of more complex derivative and structured investment products, came new challenges for interpreting their credit worthiness.
We have long believed that the credit rating firms if anything are often late to the party, rather than conflicted by relational "coziness" with the companies they rate. Our biggest criticism of the rating agencies; they do not downgrade promptly enough.
Although the credit crisis revealed a gargantuan failure by the rating firms to anticipate the severity of the calamity, it in no way suggests the CRAs were engaged in illegal or fraudulent activity. There will always be interpretive bias to any credit analysis, but the flaws in an evaluation are more likely to be the result of errors in the model inputs and criteria.
In this case, the assumptions and evaluation processes used in CRA models might have been altruistic in their intent, but painfully (and historically) irrelevant to the outcome.
A classic example of such poor forecasting can be observed in the events leading up to the demise and bankruptcy of Washington Mutual. We discussed our concerns with S&P's latency to the then failing thrift's problems back in 2008. This is relevant for several reasons.
- Historically, Fannie Mae had purchased almost 100% of WAMU's loans.
- However, as WAMU stepped-up issuance of option-ARM loans, Fannie Mae decided this was too risky and essentially walked away from their relationship with WAMU.
- The question is why did it take so long for the rating firms to factor this into their evaluations?
Political Risk: As mentioned previously, the DOJ suit against S&P would mark the first federal crackdown against a major credit rater. Thus far, federal prosecutors have had limited success in holding the banks accountable for their involvement in the events leading up to the crisis.
State pension funds such as California's CALPERS will likely be party to state initiated actions as they too were victim of bad timing or bad decision making. Other state retirement systems with previous exposure to derivative mortgage-backed asset instruments include Illinois, North Carolina and Wisconsin. Unfortunately, under-funded public sector pension schemes are a growing concern these days.
From a potential liability standpoint this raises additional questions and potential conflicts. If a system trustee, portfolio manager or fiduciary loses money on their structured product exposure, who is at fault?
Example: If a pension administrator is compelled by a legislative mandate or contractual obligation to rely (whether exclusively or not) on ratings issued by a CRA as criteria for determining suitability of a structured product investment, who would be liable for the losses incurred?
To a cash-strapped state or municipality, an attorney general or county prosecutor might have ample incentive to seek monetary damages from MHP. However, in what capacity does the rule of law apply in their respective claims for damages and to whom will it benefit?
The consequence of political motivation is one thing, but unrealistic rate-of-return assumptions and excessive allocation exposure to risk assets are a different matter altogether. If you thought corporate pension liabilities are problematic, public-sector obligations might be a nightmare in comparison. Consider the plight facing Illinois Governor Pat Quinn when he makes his "state of the state" address later this week.
As for the federal government, when there is no political will to hold policy makers and bankers accountable, then bullying a credit analyst or CRA firm with civil action would appear the easier route to extract fines and penalties. Therein lays the rub. If lawmakers, financial institutions and regulators were unable to anticipate the credit crisis, might it be reasonable to assume that credit rating evaluations would miss the boat too?
Empirical Analysis: One of the more interesting studies on the CDO market meltdown can be viewed here. Below is a condensed abstract summarizing opinions presented in the report:
- Collateralized debt obligations (CDOs) have been responsible for $542 billion in write-downs at financial institutions since the beginning of the credit crisis.
- Poor CDO performance was primarily a result of the inclusion of low quality collateral originated in 2006 and 2007 with exposure to the US residential housing market.
- CDO underwriters played an important role in determining CDO performance.
The failure of the credit ratings agencies to accurately assess the risk of CDO securities stemmed from an over reliance on computer models with imprecise inputs.
- Overall, problems in the CDO market were caused by a combination of poorly constructed CDOs, irresponsible underwriting practices, and flawed credit rating procedures. --From Anna Katherine Barnett-Hart's presentation to Harvard Department of Economics
Invest in MHP or MCO? (The baby and bathwater scenario)
Obviously, some blame can be laid at the feet of the credit rating agencies for their role in the credit crisis. Does this DOJ and "event" driven pull-back in the share prices of MHP and MCO present a buying opportunity?
Valuation wise MHP looks to be the less expensive stock, trading at 12 times cash-flow and 8.5 times book value. In contrast, MCO trades at more than 15 times cash-flow, but operating margins are a generous 39% versus 29% for MHP.
We expect shares of MHP to remain volatile near-term as details of the case become more clear and scrutinized by the media. As a civil case, the burden of proof would be lower than a criminal complaint, but the government will have to prove intent. Litigation is costly and concerns about the duration and direction of a civil action will likely weigh on investors near-term.
Moody's on the other hand, looks to be the better "bounce" candidate despite its richer valuation. MCO is not party to the DOJ or any other complaint (as of this writing), but it has been cast in the spotlight.
Yet, a 20% haircut in the stock over the course of several days makes MCO tempting as a trade. If shares are able to hold above the $45 area we would consider a retracement back to $50 as a short-term objective. If MCO violates $45, the next level of support would be $38-40.
Conclusion: The DOJ action against MHP and its S&P unit sends mixed signals to the business community, investors and taxpayers. Monetary damages sought by US prosecutors are $5 billion. How the DOJ arrived at this figure is not clear, but pre-filing talks between government officials and S&P did break-down as a result of failure to reach a settlement agreement.
Additional and ancillary litigation by state, municipal and other shareholder suits would potentially add indeterminable costs to the outcome. Clearly, if the federal government is willing to accept that too big to fail is too big to jail then the threat of civil prosecution is the next logical step down the food-chain ladder.
Nobody ever went broke underestimating our current state of political dialogue in this country. However, unless prosecutors are able to uncover damaging smoking-gun evidence and irrefutable proof that S&P (or any other CRA) fraudulently inflated their credit ratings, we view the DOJ action against MHP as somewhat suspicious to the objectivity of enforcement.
Meanwhile, MHP and MCO are currently trading at a significant discount to their share prices earlier this week.