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Moody's Reveals the Incompetence of its Own Ratings!!!

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May 30, 2008 – Comments (3)

The implications of this article are far-reaching:

1.)  Actual risk rating on Ambac and MBIA should be Caa1; 15 notches below JUNK!!

2.)  Systemic inadequacies in the way Moody's rates risk have been established and even conceded by its own analytics unit.

3.)  This is potential fuel for investor lawsuits.  Few have discussed the potential scale of investor lawsuits that could ultimately result from this crisis.  I think one reason we haven't seen more litigation activity is due to the complex nature of the instruments themselves.  People are still fact-finding about what they are, as that must be established before contrasting that to what they were represented to be to potential investors.  I'm not a fan of the litigious nature of this country, but I nonetheless think that financial firms' exposure to lawsuits is one factor many are overlooking.

4.)  Moody's credibility has been damaged by these events for some time now in my opinion, but this new development certainly exacerbates their embarrassment and suggest a new paradigm and a new process are required for assessing investor risk.

Implications 5 through Infinity correspond to each of the investment products rated by Moody's... what is their REAL risk to your portfolio.

 

http://www.bloomberg.com/apps/news?pid=20601087&sid=a0tWb0sTTgu8&refer=home

Moody's Implied Ratings Show MBIA, Ambac Turn to Junk (Update1)

By David Evans

May 30 (Bloomberg) -- Moody's Investors Service has created a new unit that surprises even its own director.

The team from Moody's Analytics, which operates separately from Moody's ratings division, uses credit-default swap prices as an alternative system of grading debt. These so-called implied ratings often differ significantly from Moody's official grades.

The implied ratings frequently show that swap traders think debt is in more danger of defaulting than Moody's credit ratings signify. And here's the kicker: The swaps traders are usually right.

``When I first saw this product, my reaction was, `Goodness gracious, Moody's has got a product that is basically publicizing where the market disagrees with Moody's,''' says David Munves, managing director for credit strategy research at Moody's Analytics. The implied-ratings unit works in a corner of Moody's new world headquarters in lower Manhattan, across the street from Ground Zero.

``But these differences are out there,'' Munves says. ``We might as well capture and learn from it what we can.''

The credit quality of bond insurers, which have been at the center of the subprime storm, differs dramatically. The official ratings of these companies say the insurers are in great shape; the alternative ratings say they're in dire danger of defaulting on their debts.

MBIA Inc. and Ambac Assurance Insurance Inc., the two largest bond insurers, got themselves into trouble by veering away from the plain-vanilla business of insuring debt issued by municipalities and corporations. The insurers began selling credit-default swaps, which are a type of insurance, to banks eager to hedge their own risks from collateralized debt obligations.

Subprime Debt

Because many of those CDOs were bundles of debt laced with securitized subprime home loans and other asset-backed securities, the insurers might now shoulder tens of billions of dollars in losses.

Ambac and MBIA have raised billions of dollars of new capital so that Moody's and Standard & Poor's would keep top ratings for the bond insurers -- and the rating firms have done just that.

Moody's implied-ratings group paints a completely different picture. Using CDS market prices, Munves's unit assigns implied ratings of Caa1 to both MBIA and Ambac. That's seven notches below junk and 15 below the official Moody's rating.

Swap traders see there's a huge risk that Ambac and MBIA will default, hedge fund adviser Tim Backshall says. He says swap traders don't trust S&P's and Moody's investment-grade ratings for the companies.

`Into Default'

``The only thing holding them at AAA is simply the model that the rating agencies claim they use to judge that capital and the fact they know that if they downgrade the companies, it'll push them into default,'' says Backshall, of Walnut Creek, California- based Credit Derivatives Research LLC.

MBIA spokesman Kevin Brown says the official investment grade ratings are justified. ``Credit default swap spreads, in our opinion, are an indicator of investors' sentiment, as opposed to an objective measure of risk,'' he says.

Brown disagrees with Backshall's conclusion. ``There is nothing about a downgrade that would in and of itself trigger a default. We don't think that's going to happen.''

Ambac Chief Financial Officer Sean Leonard says the credit default swap market may not accurately portray a company's debt quality.

``It's not an efficient market,'' he says. ``There are technical factors, like supply and demand imbalances, in the credit default swap price that don't reflect our fundamental ability to make payments on claims.''

`Will Not Refrain'

The rating companies say their grades are correct.

``Moody's will not refrain from taking a credit rating action based on the potential effect of the action,'' says company spokesman Anthony Mirenda.

S&P spokesman Chris Atkins says, ``We make rating changes when we believe events warrant such action.''

Munves says that over one year, the implied ratings have been a more accurate predictor of defaults than Moody's ratings. The Moody's unit reports that implied ratings for one year have a 91 percent accuracy ratio compared with an 82 percent ratio for Moody's official ratings.

``The Moody's accuracy ratio is consistently lower,'' he says.

He says Moody's company debt ratings are designed to remain stable so they aren't influenced by short-term ripples, unlike the more volatile swap-implied ratings.

``The CDS market often ends up coming back towards Moody's rating,'' he says.

By the time the two ratings converge, though, a company's debt may already be in default -- and the investors who bought it may be out of luck.

Editor: Jonathan Neumann

To contact the reporter on this story: David Evans in Los Angeles at davidevans@bloomberg.net.

Last Updated: May 30, 2008 14:03 EDT

3 Comments – Post Your Own

#1) On May 30, 2008 at 9:22 PM, anchak (99.85) wrote:

Good topic.....I couldn't agree with all the conclusions that you drew from the article though.

The obvious ones that I agree

(1) Moody's need to update and rethink their rating methodology. I think their problem is that they evaluate everything on a singleton basis - thus a small $400MM pool for some giant like AIG can really bear no capital risk and the backing of the counterparty and the credit enhancement provided may be adequate for it to be rated AAA for that instance. However, they do these like production pipeline - and hence IMHO miss the systemic risk.

For eg. GE has an unwritten policy of their debt being AAA rated - irrespective of underlying collateral. So they will go ahread and use GE corporate guarantee and credit enhance it - however enhancement never requires you to escrow the entire default risk - only a portion as deemed by Moody's. Thus if all GE debt all over the globe came and started going sour - they would also have some real problems - but then again we are talking of a serially correlated event on a global scale - those dont happen do they ? ( Hmm....where did I hear the word Black Swan..ahem)

Anyway ultimately a question of chance/probability.

(2) The though that they are trying to sanity check with the CDS market - is smart. But that's where you need to stop - it can be a factor not the ultimate driver.

This is where I disagree  - you teed off with this. The CDS market is a clear hedging arena - and is controlled by a few big players - you'll see dwot talk about JPMs derivatives exposure - they I believe are one of the primary market makers of CDSs.

So in this environment ( panick) - everybody wants to pay a premium to cover their A$$ if possible. Spreads are astronomical - directionally correct , but magnitude - who knows.

 Its like using this cool tool I picked up from one of the Fool's blogs which shows the Max Pain point on Options - same theory right - can you use that to predict Stock prices - but its an indicator nonetheless.

 (3) Ambac,MBIA - I sure have no clue - even if you believe the truth is midway - it still looks bleak doesn't it?

 OT: I'll try and post the link on Indian Gold consumption this quarter, It was a headline which flashed on the same article on Tata Motors that I researched for TDRH. Then I couldnt find it again - but I did locate 2 close ones. Your assertion on the jewellery consumption is correct - that's how India consumes ( or used to consume) gold. Now there are 2 Gold ETFs on the Indian exchange - I had a discussion with dwot on this - maybe I'll unearth that.

 

 

 

 

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#2) On May 30, 2008 at 10:01 PM, mandrake66 (94.86) wrote:

``Moody's will not refrain from taking a credit rating action based on the potential effect of the action,'' says company spokesman Anthony Mirenda.

S&P spokesman Chris Atkins says, ``We make rating changes when we believe events warrant such action.''

And on the off-chance that any of our analysts gives a rating that annoys a big customer, we guarantee that someone more pliant will do the next one.

 

The team from Moody's Analytics, which operates separately from Moody's ratings division, uses credit-default swap prices as an alternative system of grading debt. These so-called implied ratings often differ significantly from Moody's official grades.

The thought that struck me here is that Moody's is trying to have its cake and eat it too, by having an official AAA rating for the companies that need it to stay functioning, and another 'whisper' rating that has some correspondence to actual reality. That's a tightrope they could never walk without falling off, but I think they're desperate to maintain their integrity while still performing their rubber-stamping function.

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#3) On May 30, 2008 at 10:14 PM, DemonDoug (86.32) wrote:

There is a word for all of this: fraud.  IMO this is WORSE than what Arthur Anderson did with Enron.  This isn't just cooking books.  This is cooking the entire market.

I think it's time for big time analysts and publications to start really putting the pressure, not on moodys, fitch, or S&P, but on the government.  Moody's deserves no less than what Anderson got, and that's the death penalty, and I want the CEO and the COO and the CFO and the chief analyst all thrown in jail.  The fact that Moody's has it's own in-house analytics giving a more market-neutral and honest assessment, and Moody's STILL will not downgrade, and it's effect on the market, it's criminal.

I am calling especially on the Motley Fool site to do an honest assessment on this, as the Fool has praised Moody's in the past in many articles as part of their pitch for Hidden Gems.  While I do not begrudge the Fool to advertise and use their track record as a marketing tactic, I think it would do a great service to all investors and the entire market if there were a complete reversal on this, and if they were to start covering Moody's like they did with Enron.

Please check my blog entry on Moody's for further discussion.

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