Don’t Just Blame the Rating Agencies

The Financial Stability Act of 2010 includes various provisions relating to Nationally Recognized Statistical Rating Organizations (NRSRO) — Rating Agencies — ranging from Senators LeMieux and Cantwell’s laissez faire elimination of NRSROS to Senator Franken’s governmental assignment of NRSRO’s to specific bond offerings. While the extremes are covered, a middle of the road approach is missing.

Fortunately, we have been through this dance with the role of Rating Agencies once before, and the SEC came out with a prudent solution.

Every mutual fund lawyer knows that advisors to money market funds cannot blindly rely upon the the Ratings Agencies’ assessment of a debt instrument. Instead, money market fund advisors must do their own credit homework in analyzing debt instruments.  They may take into account a Rating Agency’s rating as one factor in their own analysis, but the rating can not be a substitute for their own analysis.

This issue was firmly put to bed in the early 1990’s.

A little background.  Money Market Funds are allowed to keep their share prices valued at $1.00 per share (irrespective of slight movements of net asset value of the fund) provided they abide by certain credit and diversification rules. (Set forth in Rule 2a-7).  In other words, money market funds are exempt from the basic rule that the share price of a mutual fund must fluctuate and reflect the net asset value of the assets held by the fund.

One of the core provisions of Rule 2a-7, is that a money market fund must “limit its portfolio investments … to instruments which … present minimal credit risks”. After a series of commercial paper defaults in the late 1980’s, the SEC substantially modified Rule 2a-7 in 1991.  Among other changes, the SEC, for the first time amended the “minimal credit risk” requirement, by adding the following parenthetical; “(which determination must be based on factors pertaining to credit quality in addition to the rating assigned to such instruments by a NRSRO)”.  The Commission explained that the language was designed to emphasize that:

Possession of a certain rating by a NRSRO is not a “safe harbor.” Where the security is rated, having the requisite NRSRO rating is a necessary but not sufficient condition for investing in the security and cannot be the sole factor in determining whether a security has minimal credit risks.

This simple amendment transformed the management of money market funds. For over 15 years, money market fund advisers have had to undertake their own credit analysis.  Rather than relying on the Rating Agencies, investment firms had to develop their own staff of credit analysts.

Investors burned by investments in mortgage-backed-securities and CDO’s cannot place all of the blame on the Rating Agencies for the investment losses that they incurred.  I am hardly an apologist for the Rating Agencies given the various allegations of collusion between the Rating Agencies and Wall Street firms, as well as the conflict of interest inherent in their business model in which the issuers of securities pay the fees of the Rating Agencies.  Nonetheless, investors must take some responsibility for their investment decisions.

The unanswered question in the subprime financial crisis is whether investors did their own credit analysis with respect to the various mortgage-related instruements.  Those who did, not only likely sidestepped the crashing market for these instruments, but  some made fortunes on their bets against these instruments.

Michael Burry, Steve Eisman and Robert Rodriguez, profiled in Michael Lewis’s, The Big Short and Roger Lowenstein’s, The End of Wall Street, are examples of investment professionals who did their homework and did not blindly rely upon the pronouncement or ratings of Wall Street’s standard bearers.

In my mind, the lesson is simple, particularly for investing fiduciaries.  Do your homework.  In the constellation of jobs within the financial services industry, credit analysis is neither glamorous nor high paying.  Everyone would rather be a deal-maker or a hedge fund maestro.  But with complicated investment products and volatile global markets, I want to stick with the guy who does his credit homework.  Rigorous credit analysis can never be a bad thing.  Whereas as blaming the other guy — such as the Rating Agencies — seems, shall we say … a bit unfiduciary-like.  Instead, we need fiduciaries who will raise their hands and say, “I did my homework and I take responsibility for my decisions.”

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Banks fight to maintain $22.6 Billion in Derivatives Trading Revenues

The New York Times reports today that bank lobbyists are fighting desperately to save the trading revenues from their derivatives desks.  http://nyti.ms/aaGgen.   Considering 5 banks (Bank of America, Morgan Stanley, JP Morgan, Goldman Sachs, Citigroup) dominate the derivatives business, that’s $4.5 billion per bank.  I’d also fight like hell to save those revenues.

According to the Article, “the financial industry says that derivatives are a valuable product used by more than 95 percent of Fortune 1000 companies to hedge against risks, including price changes.”  However, the issue is not whether Fortune 1000 companies view derivatives as a valuable risk management tool, but whether banks which benefit from federal safeguards should provide these products.

Yes, derivatives are a core banking product.  And yes, they provide significant profits to banks.  The question is:  Should this continue?

As I wrote in a prior post, Goldman’s Clients — Caveat Emptor, the largest banks rely upon a significant conflict of interest within their basic business model.  No where is this more evident than with trading derivatives.  And as the above numbers reflect, huge bucks depend on this.

First, we must be mindful of the fact that derivatives come in all shapes and sizes, from the most simple to the most esoteric.  And, as always, when we speak in generalities we must be careful.  Nonetheless, it is safe to assume that derivatives are risk reducing tools.  These tools can be used to assist clients with managing their own risks, and they can be used among the banks themselves (and other financial institutions) to apportion risk.   I am more focused on the former than the later.

As my prior post outlined in greater detail, Goldman explains that its risk business (e.g. derivatives business) grows out of its investment banking relationships with clients.  In other words, once Goldman has secured a relationship as an advisor to a client, it then introduces the client to various derivatives strategies.

Upon entering into a derivatives contract with Goldman, the client has evolved from an advisory relationship to an adversarial one.  Counter-parties to a contract, by definition are adversaries.   If Goldman continues to cultivate the advisory relationship (which of course it will), while at the same time maintains and cultivates additional counter-party relationships with the same client, it has entered into significant conflicts with this client.

On the one hand, where the derivatives are plain vanilla interest rate swaps, there are fewer concerns.  That is, many Fortune 1000 companies have expertise within their own treasury departments to make informed decisions about entering into a derivatives contract.  However, quite frankly, the banks don’t make a lot of money of these transactions. Instead, it is in the highly “bespoke” arrangements where the banks both earn the most money and undoubtedly where the clients rely upon the bank’s advice the most.  This is precisely where the greatest conflicts lie.

Again, I don’t mean to pick on Goldman, this is rampant throughout the industry. Not only is it rampant, but these very conflicts help to turn on the lights every day.  For instance, JP Morgan Chase reported $3.3 billion in earnings for Q1 2010 on revenues of $8.3 Billion.  Therefore its $4.5 billion share of derivatives revenue, constitutes about 12% of its revenues (assuming Q1 revenue numbers are annualized).   We are not talking about insignificant numbers, here.  This is worth fighting for.

The other point is that in light of Goldman’s recent challenges concerning the ABACUS deal, many people think of complicated synthetic mortgage backed instruments when the topic of derivatives is raised.  However, the term derivatives encompasses many types of instruments which are sprinkled throughout corporate America.  They are not some isolated, esoteric, rarely used instrument.  They have become a bedrock of the financial industry.   That is why the battle is so heated.

Whether the banking lobbyists are successful in retaining the derivatives trading desks within the banks, or whether the desks get pushed out into affiliated entities, in my mind, the most insidious aspects of derivatives trading will continue — the fact that the bank serves both as advisor and counter-party.

Clients, commentators, policy makers, advisors and bankers themselves need to be aware of these conflicts.   As Justice Brandeis once said, “sunlight is the best disinfectant”.

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