Reining in the Rating Agencies

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Through the ongoing and mind-numbing complexity of the European sovereign debt crisis, the bureaucrats in Brussels can be relied upon to introduce some absurdity into their deliberations. The latest is a report in the FT that under certain circumstances  the EU will suspend the ability of rating agencies to evaluate sovereign credits. Now it’s true that markets are generally too reliant on credit ratings issued by S&P, Moody’s and Fitch. The basic business model of charging the issuer for the rating is fraught with conflict, as catastrophically revealed during the sub-prime crisis. However, alternative models are hard to identify – increased competition among rating agencies would likely cause a “race to the bottom” in which issuers would flock to those with the most forgiving standards. And charging investors, the actual users of the ratings, is regarded by many as unworkable.

But the downgrade of U.S. debt that occurred in the Summer highlighted the absurdity of the rating agencies evaluating sovereign debt. Unlike a corporate issuer where a detailed financial analysis encompasses most of the necessary work, sovereign credit analysis incorporates a political judgment as well. The U.S. downgrade in the Summer illustrates the rating agencies straying beyond their expertise. U.S. creditworthiness is based to a large degree on a willingness to repay debt, and an opinion on which is as much political as it is financial. The rating agencies have no more insight on the politics than many other informed observers, and as such their opinions ought to be irrelevant except for the fact that so much bond investing is rules-based driven by the ratings that these agencies issue. Many bond investors are required to hold issues with minimum ratings from the three Nationally Recognized Statistical Rating Organizations (NRSROs), otherwise known as S&P, Moody’s and Fitch.  But really, since sovereign issuers have the ability to tax, their credit ratings are by nature not simply financial. The ratings frankly shouldn’t carry any more weight than other sell-side research on bonds.

As sensible as it might seem to ditch the legal support for NRSRO-issued sovereign credit ratings, the EU bureaucrats in Brussels have revealed their own muddled thinking in the latest proposal. No doubt France’s impending loss of its AAA rating, a possibility the French regard with horror but which financial markets have already moved past, is the catalyst. The FT reports that under proposed EU regulations ratings will be suspended during times of financial stress. So good ratings are fine, but bad ones are not. And presumably the EU’s credit experts will anticipate trouble by suspending ratings prior to a downgrade, therefore providing an eloquent and informed signal to investors that perhaps those bonds are not quite as safe as previously thought.

In the U.S. we can be grateful that we don’t subsidize such entertaining idiocy with our tax dollars. It must be more frustrating for those sitting in Europe.

The IMF Will Need to Bail Out Europe

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The FT has a very good summary of the current state of play in the European debt crisis. Yet another weekend summit critical to the survival of the Euro is upon us. Once again, bottom-up analysis of investments is held hostage to the macro issues at play.

The EU is designed to seek consensus and is antithetical to the type of strong leadership now required. Since no single leader will be held responsible if the whole edifice crashes down, all the political calculations are based on domestic politics. It’s democratic, but ill-suited to the problems they’re facing.

The FT article highlights some important points regarding the European Financial Stability Facility (EFSF). Although €440 billion sounds like enough money, particularly if used as a first loss guarantee (theoretically increasing its firepower by 4-5 times) that’s not what’s really available. Prior bailouts of Greece, Portugal and Ireland have reduced this to  €250BN – and unsurprisingly these countries have withdrawn their pledges to the EFSF. In addition,  €230BN comes from Spain and Italy, and since Spain is quite possibly one of the future recipients of bailout funds the ultimate available funds shrink further.

For many months it’s been clear that German taxpayers would be writing a check – either to Greece or to their bondholders. But even that is looking less clear without sufficient bailout funds available. So it appears that the IMF will ultimately ride to the rescue. They’ve apparently already been asked, but the U.S. and U.K. both opposed such a move. One can only imagine the outcry in Congress at such a move. So making such support politically acceptable will no doubt require another round of robust risk reduction, since only when voters are poorer will they accept the need for U.S. money to bail out Europe.

But of course the U.S. is a net debtor as well. Things will work out – they invariably do when there’s no alternative. But the stage is set for macro issues to overwhelm everything else.

Force-feeding Capital to European Banks

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There can be little doubt that the European sovereign debt crisis has finally drawn the full attention of Europe’s leaders. After following events from a more than discrete distance, it is starting to look as if a consensus is evolving around three principles:

1) Greater write-down of Greek debt

2) More realistic stress tests of Europe’s banks with a view to requiring them to reach 9-10% equity capital to risk-weighted assets over a fairly short period of time

3) Using the EFSF as a guarantor of first loss on sovereign debt, in effect increasing its firepower to €2 trillion or more.

The European Banking Authority’s (EBA) last stress tests identified only €2.5 billion in capital shortfall for the entire region, a ludicrously low figure that lost them great credibility. Mike Cembalest, JPMorgan’s Private Bank CIO, memorably commented that the number was so low he thought the results were being released by country alphabetically starting with Andorra. At the same time the IMF’s estimate of the needed additional capital was €100-200 billion.

However, there is a problem with forcing banks to raise additional capital. They may instead decide to shrink their balance sheets instead, a prospect noted in the FT today. Issuing equity at 0.5 X book value is scarcely an attractive proposition and selling assets must be a realistic alternative. But that could well lead to a sharp slowdown in lending, further hampering the EU region’s efforts to avoid (or emerge from) recession.

George Soros floats an interesting suggestion that governments should first unconditionally guarantee their banks to stabilize them, following up with recapitalization later when their share prices have presumably recovered.

While it’s positive that constructive solutions are now receiving consideration, holders of risky assets can still benefit from being short the Euro. The € continues to be the focal point of the global slowdown. We are long ProShares UltraShort Euro (EUO) as a hedge against other types of long equity risk in our hedge fund. The risk of a complete disaster is receding, but the solutions don’t look to be positive for European growth.

 

Disclosure: Author is long EUO

The Principal Agent Problem in Private Equity

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Peter Morris has written an interesting article noting the principal-agent problem as it relates to investors in private equity. Peter spent 25 years working in financial services and is the author of a report written for the Center for the Study of Financial Innovation (CSFI) called Private Equity, Public Loss? Peter and others have pointed out the disparity between low returns earned by private equity investors and the ample compensation earned by the managers of those investments. The principal-agent problem Peter notes is not unique to private equity of course, but he makes a good case for much greater transparency around results for such investors and challenges the notion that “sophisticated” investors are well equipped to make well informed decisions in this arena. Investors in hedge funds have suffered through similarly poor results as Peter also notes, and he kindly refers to a book I have written called The Hedge Fund Mirage which explores this issue.

There are interesting public policy issues surrounding this entire area, in that public pension funds are increasingly allocating capital to alternative investment strategies in the hopes of reaching the 7-8% return targets they need to meet their obligations. Ultimately, a failure to meet those goals will have consequences for taxpayers throughout the developed world as workers retire if pension plan returns fail to met expectations.

How UBS mismanaged its way to a profit

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The good news from UBS today is that they expect to post a modest profit for the third quarter.  This is in spite of losing $2.3 billion through the unauthorized trading of Kweku Adoboli. On top of that, the woefully inadequate risk oversight that Mr. Adoboli so painfully exposed has forced UBS to hasten the shrinking of their investment bank, incurring restructuring charges. However, in spite of these twin blows to their results, UBS expects to include a $1.5 billion Swiss franc profit from widening credit spreads on their debt. That’s right, because the company’s self-inflicted wound has soured investors on the bank’s prospects and therefore raised the yield on their debt, in the topsy-turvy world of accounting this is counted towards their profit. The green eye-shade logic is that because UBS owes money (on the bonds they’ve issued) the lower price for the bonds implies the value of what UBS owes has gone down. It’s the same as if the investors in those bonds just decided to forgive 5% of the face value.

Of course, UBS still owes the same amount of money, and borrowing just became more expensive for them. But the Looking Glass world of liability accounting regards this differently. So when UBS announces a profit for the third quarter, remember that it came about through the market’s recognition of their weak risk management structure.

Range Resources and the Pennsylvania Superior Court

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Yesterday a court ruling in Pennsylvania cast doubt on the title of thousands of shale gas leases, as reported in Bloomberg . Range Resources (RRC) is as heavily invested in the Marcellus shale area, which includes Pennsylvania, as any other company out there. The company is well run and we like the management. The stock has also been exceptionally buoyant recently on takeover rumors. However, this news will likely put any potential acquisition on hold until the title issues are resolved, either by the Pennsylvania State Supreme Court or through state legislation. We are not currently invested in RRC although had been invested until recently when the U.S. Geologic Survey revised down their forecast of total reserves available in the Marcellus (which runs from NY State to Tennessee). This may create an opportunity to invest at lower prices once the story has had some time to play out.

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