David Einhorn vs. the Credit Rating Agencies

Naked Capitalism provides a summary of a a fascinating speech by David Einhorn regarding the credit rating agencies.

He wants the agencies to lose their exemption from Regulation FD, thereby ensuring that any information that the agencies see becomes public information.

He claims that each type of bond a different rating scale is used with a different “idealized default rate”, and that ratings are assigned to individual securities relative to their idealized rates. Thus, he says, “an A rate muni has the same chance of default as a AA/AA- rated corporate and a AA+ rated CDO. When municipal bonds default the expected recovery rate is 90% compared to 50% on corporates and CDOs”. I have started digging into this and found idealized structured finance default rates (figure 27, page 30 of the pdf). I’m continuing to check this statement.

He also made a good point about “mark to make believe”. Ellington management, a large hedge fund participant in the mortgage business, suspended redemptions because it couldn’t determine the value of its assets. Apparently they owned a lot of “20/90” bonds, so called because they’re 20 bid, 90 offered. They got roasted in the media. The brokerages own similar assets, but instead of saying they could not prepare their quarterly financials, they moved the assets to Level 3 “Mark to make believe” under FASB 157, and assigned them their best guess of fair value.

He has many critiques of the business … and an ad for his forthcoming book! Read the whole speech, it’s very well done.

Update, 2007-11-19: Thanks to Accrued Interest in the comments for putting me on the right track – I found the Moody’s study, dated 2002Moody’s US Municipal Bond Scale:

Like the bond markets themselves, Moody’s rating approach to municipal issuers has been quite distinct from its approach to corporate issuers. In order to satisfy the needs of highly risk averse municipal investors, Moody’s credit opinions about US municipalities have, since their inception in the early years of the past century, been expressed on the municipal bond rating scale, which is distinct from the corporate bond rating scale used for corporations, non-US governmental issuers, and structured finance securities.

Just for fun, I started looking up “Brookfield” – I know that’s the name of several rated municipalities, I see the name all the time when looking up a certain well known corporation – and, right beside the list of possibles, I see a link to The U.S. Municipal Bond Rating Scale: Mapping to the Global Rating Scale and Assigning Global Scale Ratings to Municipal Oblications dated March 2007:

In recent years, the lines separating the U.S. municipal market from other global markets have become increasingly blurred as growing numbers of “crossover” buyers invest in municipal bonds for various reasons. The market overlap is caused partly by U.S. municipalities issuing more debt in the taxable market, and partly by global investors who may not be subject to U.S. income taxes but are nevertheless purchasing municipal bonds for portfolio diversification and other purposes not linked to the debt’s tax-exempt status.

In response to these developments, and in an effort to provide greater transparency about the meaning of our ratings, Moody’s has spent the past five years refining our analytical approach for expressing the relationship between the U.S. municipal scale and the global rating scale.

If it was a secret, they don’t appear to have kept it very well!

3 Responses to “David Einhorn vs. the Credit Rating Agencies”

  1. accruedint says:

    After all this time, I finally got a login, so now I’m going to actually comment…

    Anyway, the muni stuff is right. Moody’s has a report somewhere on their website where they show that most A-rated and many Baa-rated munis would be rated Aaa if they were rated on the same criterea as corporate bonds.

  2. […] Now, I would like to hear more information about the proposal to lift the exemption from Regulation FD that now applies. But Mr. Stern admirably summarizes the major issue. […]

  3. […] Naked Capitalism does not explain why all fault lies with the Credit Rating Agencies and not with the issuers and investors; nor does he speculate why Moody’s, for instance, would choose to publish explanations of their municipal rating scale if it’s such a big secret. […]

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