Friday, October 28, 2011

What Value the Rating?

I often ask myself how valuable any sell-side research can be, given the obvious conflicts being suffered through by a banks’ research team. The attributes that undermine the effectiveness of a banks’ research analysis are numerous – here are some:

1. the bank typically has many more buy recommendations than sell recommendations (The Big Short’s Vincent "Vinny" Daniel neatly captures the conflict when he says “You can be positive and wrong on the sell side,”… “[but] if you’re negative and wrong you get fired.”)

2. similar to the prior point, the uneven distribution of ratings renders the “buy” rating less meaningful

3. the accuracy of a rating isn’t easy to test, as its term and range isn’t always well-defined

4. the rating changes with regularity, and so never adjusts or converges to a final number, so the same analyst may appear right then wrong then right again. Were they right, overall? (see for example “S&P upgrades Google stock days after "sell" view”)

I remember chatting, a while back, to a former sell-side research analyst from a so-called Yankee Bank about what it was like rating stocks during the heat of the financial downturn (2007-2008).

He commented on the futility of his position: his predictions may just as easily be right as wrong, given the heavy influence of emotions, or market technicals, rather than any reliance on company fundamentals – which he was being asked to judge.

But he also described his position as awkward: in a market in which he truly expected almost everything to keep going down, he wasn't in a position to issue sell ratings on all his stocks. Why maintain a buy rating, or a hold, if you really think the client out to sell? But what effect would be produced if you put a sell rating on everything? Putting a sell rating is bad for business, and by way of the influence banks wield in providing ratings, serves only to increase the likelihood of a further decline, or to exacerbate that decline.

So in a down market, we have an influential bank analyst, who otherwise provides useful market color, feeling his position to be both awkward and futile.

I remember his remarks from time to time, especially when people ask me what I think of the US downgrade by S&P or the downgrading of other sovereigns like Italy or Spain.

While the downgrade may or may not be the right action, from a legal perspective based on the code of NRSRO ratings, one has to wonder what the benefit may be. If the downgrade action reflects the rater's perception that a sovereign entity may struggle to raise funds – as was the case in the Italy downgrade action – the actual downgrade itself only serves to heighten the sovereignty's difficulties in raising such funds. Economists often call this a self-fulfilling prophecy or a self-effectuating phenomenon.

As opposed to the threat of downgrade hanging like Damocles' sword above a finance minister, encouraging him/her to get the country's finances in order, the downgrade action serves little purpose - only making it harder to get one's finances in order.

And thus the duality of the position: can one credibly support an action that only serves to exacerbate a difficult situation, while helping nobody (aside, perhaps, from short sellers and political opponents to controlling regimes or parties).

The bank analyst felt his position to be futile and awkward. The rating analyst may struggle to sleep: his or her option is to defy the company's code, or to be destructive.

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