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Skeptical Investor Puts Trust In Ratings Agency

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You may be aware that noisy Asia-focused short-seller Muddy Waters is in a fight with Singaporean agricultural commodity trader Olam. Muddy Waters thinks that Olam is "an extreme example of an increasingly important conflict in modern finance: the clash between accounting and business reality," and that "it is instructive to view Olam through the lens of failed US trader Enron Corp." Olam disagrees, vehemently and litigiously. You can read all about it at your leisure (pro, con); I am not an idiot so I will carefully avoid taking any position on who is right and by how much.

Our question today is instead: are S&P idiots? Here is Muddy Water's latest offer:

We hereby make a bona fide offer to pay for Olam to have one of its public debt issues rated by S&P. ... The Company has never before had a debt rating, and having Olam’s debt rated by S&P would be an important step toward improving the Company’s transparency. Because we will pay the expense, Olam has no good reason not to have a rating.

I love this move! On its surface this is a pretty straightforward proposal. Muddy Waters thinks that Olam is - to use simple words - a big fraud, but the only way to really know is to have inside information,1 which Muddy Waters lacks. Olam has plenty of inside information but (1) has a vested interest in persuading people it's not a giant fraud, whether or not it in fact is, and (2) can't reveal every piece of inside information to everyone for reasons both practical and competitive-secrecy-y.

So a reasonable solution is for Olam to reveal all its inside information to an impartial third party observer who is in the business of evaluating debt, who is allowed to get inside information, and who will keep it confidential except to use it in formulating a rating. Presumably the expected rating would be pretty binary: S&P comes back either "yep, healthy, all is good," and Olam's bonds rally back to the ~6% level where they priced a month ago,2 or it comes back "sorry, huge fraud!" and Olam's bonds crater to … I dunno, Muddy Waters thinks they're worth 14-33 cents, with the equity having "nuisance value at best."3 S&P could just solve everyone's problems.

Sort of. The inside information that raters typically get is in the form of management conversations and projections, not tire-kicking around fraud. S&P are not particularly trained to root out fraud and disaster, as everyone who has ever said anything about S&P will tell you.4 S&P are, to a large extent, doing what everyone else does - evaluating the quality of the accounting, the amount of leverage, the firmness of the CEO's handshake, etc. - with a few extra handshakes and a touch more forward-looking information.

And that's fine because they're generally not in the business of rooting out fraud or advising people where to invest. On the classic issuer-pays model of credit ratings, S&P are just idly expressing their opinions; they have no duties to any investor, and can't really get in trouble for getting their opinions wrong.

That changes a bit when there are specific identifiable investors who S&P knows are relying on its ratings. One could imagine that, if Muddy Waters is paying S&P to rate Olam, S&P might feel some duty - or some such duty might be imposed by some court somewhere sometime well after the fact - to actually get the rating right. (I mean, Muddy Waters is paying for it! They're practically the client.) Plus of course S&P is on notice that at least some people think there's fraud, so the old "how could we know there might be fraud?" defense is not available.

So they'd look pretty bad, legally and reputationally, if there's fraud and they don't find it. And on the other hand, if they do come out with an F-for-Fraud-type rating, Olam will be pretty mad, in a yelling-about-conspiracies-and-market-manipulation kind of way. And either way, it's hard for S&P to be all that confident in their conclusions, since they're relying on management and have no special fraud-sniffing skills. And neither Olam nor Muddy Waters are afraid of suing everyone they come into contact with.

If I ran S&P, I would resist this assignment: I'm just getting paid my regular, non-controversial, no-liability, how-could-I-know-there'd-be-fraud fee for rating a regular old bond issue, but I'm doing a much more complicated and higher-stakes rating than usual, in the certain knowledge that whatever I say some well-funded, angry and litigious character will disagree with me. It's not worth it.5

Which makes this a great move by Muddy Waters! Let's say they don't know if they're right that Olam is a big fraud, but they think there's an X% chance that it is (and that their investment appropriately reflects that risk-reward). Presumably if S&P goes and rates Olam's debt, there's about an X% chance they'll conclude it's a big fraud, though for the reasons above there's plenty of variance around that number.6 So if Olam and S&P accept Muddy Waters' offer, that doesn't change the value of their trade.

But if you think that Olam and/or S&P will say no - well, how does that look to other investors? What are they hiding? And down goes the stock. S&P can help Muddy Waters as much by not rating Olam as by rating it negatively, and without the pesky risk that an actual rating might turn out just fine.

Muddy Waters Offers to Pay for Olam Debt Rating [DealBook]
Muddy Waters is Unimpressed with Olam’s Response; We Will Pay for Olam’s Debt to be Rated [Muddy Waters]
Olam dismisses Muddy Waters report findings [Olam]

1. THOUGH I MEAN: "Block also pointed to Olam’s acquisition of NZ Farming Systems Uruguay, noting that latter had recently published an annual report with the words 'fudge this' next to one of the line items."

2. Meh? That's a pretty retail bond, who knows. I see the 10-years at ~8.9% ($81) now on Bloomberg.

3. Pages 2 and 121 here.

4. Imagine a footnote as big as the earth here, but I'll give you just one sample, which is something I've already quoted about MF Global:

Moody’s and S&P also did not understand the nature of MF Global’s European sovereign exposure. Both firms believed that the European RTM trades were client-driven transactions, and that MF Global hedged the risks of these transactions. But, their understanding was inconsistent with MF Global’s public filings, which stated that the company maintained exposure to the underlying sovereign issuer and that mark to market movements associated with the European RTM trades could cause volatility in MF Global’s financial results.

S&P weren't even able to notice jump risks that were disclosed in public filings.

5. You could charge more, but how's that look?

6. Letter. Also, you could add to this pseudomath "well, if Olam accepts the offer, that means they have nothing to hide, so it reduces the likelihood that Muddy Waters is right," but I'm not sure that's particularly true.


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