Rating agencies part of banking crisis: investors

Martin Fridson, chief executive officer of Fridson Investment Advisors, speaks at the Reuters Restructuring Summit in New York September 23, 2008.

NEW YORK (Reuters) - The reactions of ratings agencies to sharply falling stock prices and widening credit default swaps have been one of the key problems in the past few months as short-sellers targeted financial firms, two investors who specialize in distressed assets said this week.

Regulators in the United States, Britain, Canada and Germany are blaming short-sellers for the rapid declines in the share prices of major banks and have imposed unprecedented temporary bans on the short-selling of financial shares as they seek to head off what is threatening to be the worst financial turmoil since the Great Depression.

However, some say their target is misguided.

Financier Wilbur Ross, who is known for rescuing troubled companies, asserts that short-sellers have played an indirect role in the current crisis as rating agencies increasingly rely on stock prices and credit default swaps to come up with companies' credit ratings.

"Of late the rating agencies ... seem to be looking at stock prices and the credit default swaps as a guide to what their ratings should be," Ross told the Reuters Restructuring Summit this week.

"To the degree they do that it makes you wonder if you even need the rating agencies any more," he added, since the prices of the stock and credit default swaps are already public information.

Andrew Feltus, senior vice president and portfolio manager at Pioneer Investments, also said rating agencies should share the same scrutiny as hedge funds.

"You've had a dynamic now where people just short, short, and short and it drives down the (stock) price," Feltus said. "Then the rating agencies say, 'There's something going wrong here, the stock's falling, I better downgrade.'"

That triggers a series of events where financial firms have to post more collateral to obtain credit to keep running, and essentially pushes the companies out of business, Feltus said.

In a short sale, investors borrow shares and sell them, betting that the stock price will fall. The goal is to buy the shares back at a lower price, allowing the investor to return the shares to the broker while taking a profit on the spread between the original sale price and the cost of buying back the shares.

For institutional investors trading in hundreds of thousands or millions of shares, the short sales of Fannie Mae, Freddie Mac, or Lehman Brothers in the last year as their shares have fallen precipitously could have resulted in huge profits.

S&P, MOODY'S SAY NOT SO FAST

Standard & Poor's, a unit of McGraw-Hill Cos Inc (MHP.N), said the price fluctuation in a company's securities is just one barometer that figures in their ratings, but it is not the determining factor.

Spokeswoman Mimi Barker said S&P looks at a number of factors to help the firm gauge an issuer's ability to raise additional capital, including dramatic movements in credit default swap spreads and stock prices.

"The markets are very fluid, but those movements alone do not determine a ratings action," Barker said. "S&P takes the ratings actions as appropriate, based on the qualitative and quantitative factors that are important to the rating and without any outside influence."

Moody's (MCO.N) Chief Credit Officer Richard Cantor said, "Market sentiment is not a formal consideration in Moody's rating methodologies. However, for firms that need to raise capital to bolster their financial positions and offset the impact of recent credit losses, their ability to access the markets can be a rating consideration."

"When firms experience precipitous declines in their stock prices, they may become unwilling or unable to execute their capital raising strategies, which is a relevant consideration in our rating process."

Martin Fridson, chief investment officer at Fridson Investment Advisors, said at the Reuters Summit that agencies are being unfairly attacked.

"Rating agencies tend to be a convenient whipping boy," Fridson said. "The biggest issue that gets raised is the conflict of interest ... the people who are rated are the ones who pay for the ratings, and I always point out to ... journalists who raise this objection to me, that newspapers write about the companies that advertise in them, and you almost never hear about any sort of corruption going on."

UPTICK RULE NEEDED

The overall issue was magnified by the removal of the "uptick" rule for short sellers in 2007, which greased the wheels for short sellers, Feltus and Ross said.

The rule, which had been in effect since 1938, required short sellers to sell shares at a price above the last price paid for a stock, or at the price of the stock's last trade if it was higher than the previous price. It was revoked last year as the U.S. Securities and Exchange Commission found it was "obsolete."

"I'm very opposed to the abolition of the zero-plus tick constraint on short selling because now it permits, and indeed almost encourages, a couple of big hedge funds to get together and literally drive a stock down," Ross said.

While the SEC temporarily banned short selling in financial shares this week and implemented other restrictions on short sellers, it has not brought back the uptick rule.

Feltus said he thinks the rule would allow short sellers to provide liquidity to the market without allowing them to easily conduct bear raids that drive the price of a stock downward quickly.

"I would have preferred just to see them put the uptick rule back in play and not change the rules of the game completely," Feltus said. Reinstating the uptick rule "would have stopped short sellers from beating down stocks but still allowed short sellers to assure market pricing makes sense," he added.

(For summit blog: summitnotebook.reuters.com/)

(Editing by Phil Berlowitz)