Tom A's Stock Picks

Credit ratings reform - change is welcome

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There have been a number of developments in the regulation of credit rating agencies - S&P, Moody's and Fitch - which will have long term effects on financial stocks such as banks and insurance companies. What has been an oligopoly, with three major players getting paid by issuers, may develop into a mixed market of 30 or more rating agencies, some paid by issuers and others paid by users or buyers. The apparent stability of the existing system has been shattered by the massive size of the sub-prime rating downgrades, and stability will not be restored until changes are made. What is needed is less conflict of interest and more transparency of information, both of which are on the agenda.

On 6/5, NY AG Andrew Cuomo announced an agreement with the three agencies. They will now require due-diligence information before rating bonds. Apparently the pressure to be easy to do business with reached a point where they were hestitant to require investment banks to provide full information on some of the books of mortgages that were being securitized and rated. The fee structure is also to be amended, so that the agencies will get paid for their work whether they are asked to provide a rating or not. Under the previous system, issuers could shop for opinions and only pay for the most favorable rating available.

Today SEC head Christopher Cox proposed additional changes to how the credit rating agencies do business. They would be required to make available the information they relied on when assigning their ratings, so that other credit rating agencies could access the information and issue competing ratings. I watched an interview he gave on Bloomberg TV and he mentioned the possibility of having as many as thirty agencies issuing ratings, compared to three today. He also proposed a separate set of rating symbols or ratings for structured finance products, either by a suffix or subscript or by a different set of letters. The problem has been that a highly rated tranche in a structured deal has a different risk profile than a highly rated conventional deal. This is particularly true with respect to standing up to credit stress and the size of maximum possible losses.

Cox also stated that the timing was good, Congress legislated reform without specifying the parameters in the fall last year, and now changes can be made with the benefit of lesson learned .

By coincidence, if coincidence it was, Moody's announced it was reviewing Ambac and MBIA for downgrade, while S&P went straight to the downgrade for both, all within a day or two of the agreement with Cuomo. S&P has been diligently downgrading bonds insured by Ambac and MBIA. I wonder if their actions reflect views on the part of Cuomo's office that he chose to implement while he had them at the table. Or maybe S&P and Moody's felt they could restore confidence in their ratings by turning on the insurance companies who support them.

The implications for the investor in financial stocks are for more downgrades and write-downs while all of this works its way through the system. Current prices for insurance companies and banks imply a substantial discount on their investment assets, many of which include formerly triple A rated RMBS. My guess is that financial stocks will continue volatile while this plays out, particularly as earnings are reported, creating some excellent buying opportunities. One thing is definite, the credit rating system is not going to be the same as it was: it will provide less apparent certainty but more and better information, so that the long term outlook is much more favorable than attempting to restore faith in the old system.