Can Ratings and Valuations Be Trusted?

| About: Moody's Corporation (MCO)

I picked up one (as usual) brilliantly funny article from the mysterious Epicurian Dealmaker the other day which linked through to a rather depressing article about how the business of giving financial advice is hopelessly corrupt.

The article was saying that financial advisors are always biased because they tell their clients what they want to hear.

And sure that’s all true, there is a lot more money to be had if a project goes ahead and you get the follow-on, than if it stalls because you pointed out that it didn’t make sense and the managers who were promoting it had somehow lost touch with reality. And if the project will take three-five-ten years to go sour…who cares?

If a project goes ahead and money is made, well you can try for a percentage, but if you save someone $100 million by persuading him not to do something, (a) how does anyone know that it wouldn’t have worked and (b) how do you work out the percentage?

I’ve spent twenty years off-and-on doing valuations, due diligence, financial projections etc…as a third party advisor; and sure it’s a lousy job. It’s not like work you seek out particularly, more like something you do when you can’t find anything better to do.

Generally the only people who make decent money in that line are the whores; I worked for them all, Arthur Andersen, every one of the Big 4, rating agencies, investment banks…putting together the story-line for big-name investors with claims to be “the richest in some little or big puddle”, corporations, governments….etc. And if you play it right they call you the “rainmaker” or the “story-teller”, and every project needs one of those.

But you have to remember that it’s up to the “King who hath no clothes” to decide who he hires, and who he listens to.

There’s a book I like which was written by a long-gone Scotsman who had a something to do with the fact that the Abu Dhabi Investment Authority has $300 billion stashed away (if you listen to RGE, or $800 billion if you listen to the FT), compared to places like Nigeria, who had just as much revenue over time but pissed it away.

It’s called the “Uncivil Servant”, who was the “old-school” Indian Civil Service, that was when the Brits had “standards”. His argument was that the job of a good “servant”, because that’s what an advisor is, is sometimes to be “uncivil”.

And sure, if every piece of advice you give is “No-don’t do it”, that’s just as bad.

Being “uncivil” is more than just covering your ass in the legal disclaimer, or putting caveats in the small-print on Page sixty-four, it’s about standing up when everyone is convinced about “Going To Albany” and saying “hang-on”.

It takes courage and character to do that. The Uncivil Servant explains how during fifteen years in Abu Dhabi he never bought any new furniture because he knew that any day he might just go over the line and so why bother? Being “uncivil” is about sometimes being “in your face” and it’s always about being unpopular.

The fact that the day never came says more about his “king” than anything else. There is a story in the book of how he told the Ruler at the time (Sheikh Zayed), that he was spending (much) too much money.

Uncivil Servant:

Once there was a king who never got told bad news.


Why was that?

Uncivil Servant:

Because once someone told him bad news and he cut off his head, after that no-one wanted to tell him bad news.


So what happened to the king? Did someone cut off his head?

Uncivil Servant:



So what’s your bad news?

One of the reasons Sheikh Zayed did so much for the UAE was that he was prepared to listen to bad news, which is something that a lot of “democratically” elected leaders have a problem with, particularly when it’s more expedient to leave that until after the election.

I recollect something that was said when Volcker pitched his “Rule” to Congress, something about “you can have as many rules as you like – someone will always find a way to get around them”. But principles are different.

I remember when I first did a valuation for some property that was going to be put into a CMBS rated by Moody’s (NYSE:MCO). I got given a check-list three pages long, with essentially about fifty boxes to tick, of course it was “confidential” and I had to sign a confidentiality agreement.

It was all sensible stuff, and I duly worked out a number that they used for the LTV and a fifteen year projection for the net cash flows to plug into the DSCR, ticked all the boxes, and the rating got done – pierced the ceiling actually - champagne all 'round and my skill as a “story-teller” was widely applauded.

I was a sub-contractor for a “Big Name” real-estate consultant, but two things, (a) I was told that on no account should I tell anyone I was a sub-contractor and (b) the reason I got the job was that no-one in the Big-Name knew how to do it. Go figure, that used to happen all the time and sure they reviewed it before it went out, but no one spotted the deliberate mistakes.

Not that there was anything (dramatically) wrong with it, and in fact the projections worked out to have been conservative, and everyone lived happily ever-after.

But there was one box that was missing, which would have been a lot harder to tick, if it had been there. The “box” that wasn’t there was “what can we reliably expect that the properties can sell for at some indeterminate time in the future?”

All I had to do was work out how much you could have sold them for yesterday, and sure I did my job, my job was to tick the boxes. It was someone else’s job to decide what boxes there were to tick.

I wrote an article recently about valuing toxic assets, and one comment I got was from someone who claimed to have spent “years” valuing RMBS and CMBS, and he said that now he had no clue. That was a big admission to make, because right now, how you value one of those is EXACTLY how you used to value them before the credit crunch.

You have a load of boxes that you need to fill in about the likelihood of things happening in the future, like defaults, pre-payments, market crashes, etc…etc. The boxes didn’t change, there just has been a realization that the way they worked out those numbers before the credit crunch was wrong.

That point became abundantly clear when TARP failed to buy any toxic assets, and became even more clear when PPIP slowly sank without a trace. The point is, if you can’t do a valuation on a toxic asset now, well, you couldn’t do one before.

The reality is that right now, because of the way the industry is structured with all the relevant information held “confidentially” by the sell-side of the equation, in many cases it’s impossible to get enough market derived data to do a valuation properly. It was always like that, just the “kings” decided that they would rather hear the story they wanted to hear.

I have two points, the first one is that International Valuation Standards anticipated all of these problems, which is why in July 2003 they wrote to the Bank of International Settlements telling them that the valuations used to assess the “value” component of assets when working out capital adequacy (all over the world), were “fundamentally flawed and bound to be misleading”.

And history shows, they were.

The second is that IVS is about principle based valuation, not box-ticking. It has a section on ethics, a section on why a valuation can be different depending on the purpose. It stipulates that you should explain to your client in plain English how you did your valuation, and there is a (hard to spot but it’s there) section on why the person doing the valuation needs to keep an eye out for whether the market is in disequilibrium or not (like in a bubble or a bust after a bubble) and what to do in such circumstances.

What it doesn’t tell you is how to do a valuation – outside of saying that every valuation should be based on “sufficient” market-derived data, analysed properly.

One of the best quips I ever saw from Warren Buffett was when he was asked, “So how do you tell if something is a good investment?” He replied, “I know how to do a valuation”, and he does, and I’m sure that the advisors that he uses know that also.

When E&Y signed off the Lehman audit they didn’t declare it was “clean”, what they declared was that it had been prepared strictly in accordance with the rules. In other words, that the boxes had all been ticked.

And well, if that’s the sort of advice you want to buy, you get what you pay for.

Right now the discussion of financial regulation appears to be focussed on dreaming up more pages and pages of boxes to tick. History shows very clearly that can only lead to one thing…more “surprises”.

Perhaps it’s time to get back to “principles”?

Disclosure: No Positions

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