Tuesday, September 22, 2009

Moody's: how did they do with CCC/Caa?

Moody's is frequently criticized for its AAA ratings given to the top tranches of various structured products, as well as to former finance titans, such as the bond insurers, but did Moody's get CCC (or rather, Caa1) right?

In what may turn out to be one of the least prescient calls of the crisis, on March 10th of this year, MCO publicized widely its Q1 "Bottom Rung": a list of about 300 companies at greatest risk of default. It happened to coincide roughly with Nouriel Roubini's World Victory Lap, and the 666 S&P reading. Back then, I created a portfolio with all publicly listed equities on Moody's list. Since equity has a residual claim, one would have thought that if the debt is rated as super risky, then the equities listed would be, in most cases, the casualties of the crisis.

It turns out that thinking contrarian on this occasion would have paid off handsomely to the person with the intestinal fortitude to do it. The mean return for these publicly traded equities since then is over 250%, with the median at 150%. There are some real stars, like American Axle, Dana or LodgeNet, clocking in at over 1,000%.

One can look a the results two ways. One way is along the lines of "in March, those shares were simply options, and they delivered an option-like return", "absolute junk rally", "high beta outperformed on the way up as it underperformed on the way down", "most were down 80-90% so they bounced back some", etc. The second way is the Jesse Livermore way: take a step back and agree that these stocks were simply on the "right" side of the market without digging for a fundamental reason: it is what it is. "Old" GM is still worth north of $600 mm. It makes no sense whatsoever from a fundamental perspective, you can read it loud and clear on the Motors Liquidation Company web site (the site itself is akin to a forgotten tombstone of a once-great).

Please note that the majority (~2/3rds) of the companies on MCO's list are private, so the results may not be representative of the whole group. In addition, many of these equities trade OTC and were/are valued at well under $1, which makes them unsuitable for most investors.

Interestingly, Moody's has not made an effort to publicize their bottom rung list for the next two quarters, which makes me think that the findings in this post are on to something. For more on MCO, I highly recommend Einhorn's earlier speech (.pdf) and more recent interview on CNBC. Of course, he is talking his book but one can discern how reasonable he is, and then decide on how to proceed. His issue is with the fallout from the wrong AAA but assuming- safely, I might add- that the debt on the bottom rung delivered returns that are even 1/4 of the equity returns, then there is a problem with the CCC/under, as well (Caa, to be technically accurate). And, unlike the AAA structured products where there has not been real history to look at, all these are "regular" operating businesses, which have been the bread-and-butter for the rating agencies on the corporate side.

Please note that the work is not warrantied. I did it for my own information.

Update 9/23/09: ZeroHedge today seems to be on the same conclusion with a more substantive screen.

Update 2 9/23/09: Now Clusterstock has an interview with a former high-ranked insider from MCO who suggests that the company should be liquidates. "Asked about why Moody’s-–which has come increasingly under fire in recent weeks--is still in business, Raynes says: "It’s like prostitution. It’s a crime but it's feeding a need."" Nice, huh? Echoes Barry Ritholtz's thesis from back when. McGraw-Hill (parent of S&P) even refused to print his book.

Moodys Q1 2009 Bottom Rung

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