Special Situation Investing

Saturday, December 09, 2006

Debt and the Ratings Agencies

Found a good article on the power that Ratings Agencies such as Moody's and S&P are currently wielding over general investors. The article points out that just a few years ago, during the bust, their was a lot of investor hatred towards these companies. However, now that the economy is steaming along all seems to have been forgiven in spite of the fact that nothing has fundamentally changed. I know, I know, fairly typical wall-street stuff but just a reminder to always be vigilant.

A few good points from the article:

At the same time, the agencies have been generating higher revenue by rating complex debt instruments called structured finance. Moody's revenue from structured finance increased 30 percent last year, while those from corporate finance rose only 7 percent, Peters wrote. Similarly, structured finance ratings contributed 40 percent of 2005 revenue growth at S&P.

That renews the question, "Are they willing to 'bite the hand that feeds' going forward? We think probably not," Peters wrote.


"Frankly, it is unhealthy for a $20 trillion tradable credit system to be subject to the whims and vagaries of the ratings agencies, no matter how well intentioned they may be," Peters wrote. "Last spring's correlation hiccup and market disruption on the heels of ratings downgrades in the auto sector is just a sneak peek of the credit world to come, in our view."

Anyone who has read this blog for awhile will know that I am not the hugest fan of debt and this just further strengthens my opinion. Debt levels keep ballooning, banks are reducing their reserves a a percentage of liabilities, equity overloaded with debt is barely marked down, it just goes on and on. I think ultimately their will be a price to be paid for this. As the value-investor saying goes, I don't have a crystal ball, but I do know a couple of things. Inflation and interest rates are at low points not seen since the fifties. Ultimately if interest rates were ever to rise, which sure as hell has happened before, a lot of these overloaded junk stocks & associated bonds that keep getting floated are in a lot of trouble.

This is not all a doom and gloom post. You will notice I said previously that companies which are overloaded with debt don't seem to be marked down sufficiently. Well by that same logic companies which are in good financial health are not being marked up enough relative to their debt-burdened peers. I think that if there is any general category of value in the market right now, this is where it is at. High quality companies with good finances are being treated like garbage by the market. Many hedge fund managers even go after them to raise more debt! I mean there is actually a derogatory term for low-debt companies, 'under-capitalized'. Well I'm not buying into Wall Street's obsession with debt. Too much of it is piggy, short-term thinking where the firms are only considering their own goals with no regard to what the future may hold. No matter what these types say, a strong balance sheet is still a good determinate of value.


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