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Opalesque Exclusive: Why Did Only One Ratings Agency Get MF Global Correct?

Friday, January 13, 2012

Ratings Agency Questions Wall Street Status Quo, MF Global Leverage, Outlines Systematic, Quantitative Approach

As Congress begins to examine traditional ratings agencies and their handling of the MF Global situation, this could open a transparent view into a system that some say is riddled with arm twisting and discretionary decision making.  Professional investors might question if such discretionary analysis provides appropriate view of risk?  Such a fissure in thinking can be seen in the MF Global saga, where only one ratings agency got the call correct.  Looking at their methodologies for providing ratings takes an interesting quantitative tact.

When Jon Corzine took over the reins of MF Global in March of 2010, optimism was high in almost all quarters, and analysts roundly applauded the move based on their perceptions of Mr. Corzine and his Goldman Sachs history of walking among corridors of power.  Mr. Corzine, for one, had a vision to transform the previously sleepy Futures Commission Merchant (FCM) into a mini-Goldman Sachs.  Concurrently there was talk within the futures and options industry that uncorrelated investments and managed futures would finally be "discovered" by Wall Street and properly integrated into a diversified investment portfolio.  Perhaps most important, investors in MF Global cheered the high-level "get" of Mr. Corzine, and traditional ratings agencies reflected this optimism in their qualitative ratings.

"Jon Corzine at the helm clearly gave the traditional ratings agencies confidence in the firm, and this was reflected in their ratings," James Gellert, president of Rapid Ratings.

"In the case of MF Global, Jon Corzine at the helm clearly gave the traditional ratings agencies confidence in the firm, and this was reflected in their ratings," said James Gellert, president of Rapid Ratings, which was one of the only ratings agencies to actually downgrade MF Global well before the firm imploded.

At the end of 2008, MF Global had a Rapid Ratings' Financial Health Rating (FHR) of 49, which is close to the 2011 Q4 industry benchmark of all financial firms of 52, which had actually slid from the 2008 level when interest rates (and FCM float income) was higher. The rating is based on a number of factors, including firm sales performance, leverage, debt service management, working capital efficiency, cost structure efficiency and profitability, among 62 efficiency ratios analyzed.  After MF Global released its 2010 performance in the middle of that year, the firm had a significantly lower rating of 26.  By contrast, New Edge, an industry peer, had a rating of 41 at this point.  This MF Global ratings drop was due to continued revenue (sales) drop, following a revenue trend that started in the previous year, according to Mr. Gellert. "The 2010 mid-year rating drop also reflected significantly worsening leveraging scores, with interest coverage ratios halving and a more significant negative compounding of the profit situation."

"The problem with rating thousands and thousands of companies using a myriad of subjective factors is you can't do it consistently," Mr. Gellert noted, sounding very much like an algorithmic trend following trader.  In fact, Rapid Ratings is different in its approach in that its ratings are entirely systematic and based on empirical data.  The process works by taking mounds of publically available information on a firm, dumping that raw data into a computer program that uses specific mathematical formulas to ultimately generate a rating taking into account industry specificity.  Unlike the traditional ratings agencies, who grade based on an alphabetic system, Rapid Ratings mathematical process generates a score from 0 to 100, providing greater granularity and a more "absolute risk" vs "relative risk" perspective.  Mr. Gellert explained the technical details: "FHR's cardinal scale precisely depicts the differences between two, and among many, different rated entities.  The ordinal, alpha scale used by traditional ratings firms only tells you a ranking that one is better or worse than another; there's nothing that guides the market to the real differences between two ratings grades.  When analyzing MF Global alone or MF Global vs another FCM or against all FCMs, there's dramatically more information value in FHRs than in traditional ratings."

In uncorrelated investments and managed futures professional investors are often advised to understand how revenue is generated to potentially expose operational bias and better prepare for risk.  The same might hold true with ratings agencies and how they receive compensation. Unlike the traditional ratings agencies, Rapid Ratings does not receive compensation from those who the firm rates.  Rather, the firm is compensated by investor subscribers to the service.  In this regard, consider the double edged sword that comes from receiving compensation from those firms upon whom the ratings are being conducted, with government debt being one such area.

"It's been an interesting dynamic in the relationship between the major ratings agencies, the European regulators and sovereign governments," Rapid Ratings CEO James Gellert


While Rapid Ratings does not cover European sovereign debt, Mr. Gellert took a bold stand on the hot topic.  "It's been an interesting dynamic in the relationship between the major ratings agencies, the European regulators and sovereign governments," Mr. Gellert noted with concern. "I hesitate to defend the major ratings agencies for anything, but the fact is if they make a ratings move, people are upset, if you don't make a ratings move, people are upset."  This is a fascinating dynamic and points to what is interesting in that with the Rapid Ratings system, "getting people upset" does not factor into the ratings decision making process. Because the system is entirely algorithmic and compensation is not derived from those being rated, political arm twisting nor is open to concealment key facts regarding the scale and scope of the government debt problem would not be obfuscated. "The traditional ratings process can be a no win situation," Mr. Gellert said.  "The qualitative process that ratings have come to take is flawed in and of itself.  Traditional ratings agencies make decisions to change ratings based on subjective decisions sporadically. They typically focus more on the initial rating than the subsequent updates."

The system is set up so that those utilizing leverage - and government debt is really the ultimate leverage usage - can remain on top of those in charge of overseeing such entities.  This topic of the financial system having significant influence over those rating or regulating the system is a consistent issue throughout a variety of issues.

"You see this play out over and over again," Mr. Gellert observed. "MF Global is one type of an example, but there are others.  Enron, WorldCom, structured products, CDOs - these are all examples of ratings by traditional agencies being stale.  They were not accurate and current perspectives of how an issuer's risk really looks."

When providing testimony to Congress in July of 2011, Mr. Gellert said ratings should be reviewed and changed if necessary on a quarterly basis.  "The ratings agencies might not change their ratings, but at least they are on the hook to be saying to the market ‘we stand by our product.'  The problem is that the current system allows ratings agencies to stand by their product in a very loose way. When considering undisclosed leverage usage, Mr. Gellert reverts back to his congressional testimony. "Ratings that are done on a subjective, committee based approach to risk management is subject to all kinds of vagary and inefficiencies," Mr. Gellert emphasized. "While some market players may arbitrage that inefficiency, the overall market is not best served."

For further information visit: http://www.rapidratings.com/



 
This article was published in Opalesque Futures Intelligence.
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