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Friday, July 13, 2007

Wall Street: The More Things Change…

Two seemingly unrelated issues cropped up recently which may have more to do with one another than meets the eye. One the one hand, the Wall Street Journal reports that a Bear Stearns analyst was absurdly bullish on the sub-prime mortgage market that his bank’s proprietary trading desk, clients and hedge funds were so heavily invested in. On the other hand, the market shook when the two major bond rating agencies, Moody’s and Standard & Poor’s, finally lowered the ratings on hundreds of bonds backed by risky mortgages.

Regarding both the analyst and rating agencies, there could be conflicts that would explain the performance breakdowns, which left all those who rely on their good judgment high and dry. In the Bear Stearns case, even the most outspoken Wall Street apologist has to be questioning whether the analyst’s bullish views on mortgage back securities had something to do with the bank’s own investments. To be sure, Bear Stearns categorically denies this. The firm said in a statement of their analyst: “Gyan is a top analyst with a distinguished track record, and we stand by the quality of his work.” Even still, according to reports, Bear Stearns conveniently hired a new mortgage industry analyst and based upon how the bank treats its departing employees as shown here, if I was Gyan I’d be worried about my future on Wall Street.

Analyst conflicts are nothing new, but the latest wrinkle is the role of the ratings agencies in the collapse of the CDO market. According to a recent study co-authored by Josh Rosner, a consultant at Grahman Fisher, an investment research firm, and Drexel University finance professor Joseph Mason, ratings agencies have become too close to the deals they rate and thus have opened themselves up to liability.

The authors of the study contend that unlike traditional corporate bond rating, in structured finance deals like mortgage backed securities, “the rating agency is often an active part of structuring the deal” and would be considered an underwriter like the Wall Street bank packaging the securities bond portfolio for sale to investors.

A further conflict is that as the popularity of CDO’s grew, so did the demand for the bond ratings. The more attractive the ratings were, the more ratings requests would come in, ultimately making this sector highly profitable for Moody’s, S&P and others. Assuming the secondary market took off right after the tech bubble went bust Moody’s stock price soared from $11 in January of 2001 to a $76 high in 2007. Now the stock trades for around $60 per share.

Analysts credit the surge in Moody’s stock to the CDO/structure finance market. According to the Wall Street Journal, John Neff, an analyst at Chicago-based investment bank William Blair & Co., expects Moody's total revenue from structured finance in 2005 to have reached about $681 million, up 24% from 2004 and accounting for about half the company's ratings revenue. McGraw-Hill Chief Executive Harold McGraw III cited structured finance and the CDO market as major areas of growth for S&P.

The common thread is that conflicts are not being managed carefully enough in the financial services industry. This reflects a continued culture led by hard charging, “Greed is Good” managers; ones that the industry tries to pretend are a thing of yesteryear. Put a different way, from a view of 20,000 feet, this sure feels a lot like 2000.

Oh, and one other thought. Moody’s and S & P favorably viewed Enron bonds four days before its bankruptcy. Here’s to hoping the situation isn’t totally analogous.


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