Slouching Towards Wall Street: Courting Trouble

Courting Trouble

"There is such a feeling among people, among regulators, among the political system all over the world, against the banking system, and I don’t think that’s going to change so soon."
- Sanford Weill

A fish stinks from its head – but it swims from its tail.

The markets need leadership from the political class, but they will only thrive once they regain the confidence of their weakest participants. When the small retail investor trusts the market, the world trusts the market. This is something even Sandy Weill understands.

So why doesn’t Washington?

This nation continues to suffer a twin crisis of leadership in Washington, and of confidence on Main Street. Congress and President Obama both deserve a sound thrashing for their refusal to introduce sanity to the financial markets. Six years into the Financial Crisis (and counting…) we are no nearer to a level playing field, to a powerful and effective regulator, to actively extricating Bad Actors from the industry or to creating transparency in the markets. Like so much else on your television screen today, this will not end well.

In a legal case that may determine the future of capitalism, a federal appeals court in Manhattan was the scene of a hearing last Friday which produced the bizarre spectacle of a government regulator coming to the succor of a company it has just charged with a billion-dollar fraud.

Our recent book, Fixing A Broken Wall Street ( lays out the history of Citibank and its current SEC case in lurid and angry detail, and spells out its implications for America’s credibility. As the next chapter in this nasty saga is played out, the future of capitalism hangs in the balance.

Judge Jed Rakoff (pronounced RAKE-off) of the Federal District Court in Manhattan has criticized the SEC. In 2009 he refused to approve a settlement between the SEC and Bank of America over alleged misleading proxy disclosures when BofA acquired Merrill Lynch. Judge Rakoff argued that the settlement did not disclose who was responsible for the misinformation, that the settlement did not cure the problems the SEC claimed existed at BofA, and that the amount of the fine was miniscule, compared to the financial damage suffered. Adding insult to injury, the Judge observed that the fine was to be paid by the shareholders – the putative injured party.

In November 2011, Judge Rakoff rejected a proposed $285 million settlement of SEC charges that Citigroup had committed a $1 billion fraud. Rakoff complained that the settlement provided no details of the alleged behavior, no indication of the profits Citi earned from the transaction in question – and thus no measure of reasonableness of the settlement amount – no indication of which Citi employees or executives were implicated, and no provision for a cure of underlying problems that gave rise to the SEC case.

Judge Rakoff ordered the SEC and Citi to prepare for trial, saying it was in the public interest that the case be heard in full. No sooner was the ink dry on the Order, than the parties filed for injunctive relief. The SEC and Citi joined forces seeking a court order to require him to stand down. On Friday they had their day in court – literally.

The SEC argued that Rakoff’s rejection of the settlement “conflicted with a century of judicial practice” (NY Times, 9 February, “Judge’s Rejection of Citigroup Deal Is Heard on Appeal”) and that “The court failed to give the SEC any deference.”

Regulatory agencies obtain court orders so they can enforce the terms of a settlement in the event of repeat infractions, and courts routinely sign off on settlements. In practice, though settlements contain language prohibiting repeat violations, those terms are never enforced. Firms can repeat the same violations and only have to pay another settlement. Since they settle “without admitting or denying” the allegations, you cannot say legally that a firm “committed fraud” and you especially can’t say they “committed the same fraud again.”

The theory behind settlements is judicial economy: court hearings drain taxpayer money and lengthy proceedings tie up critical legal resources. Outgoing SEC enforcement chief Robert Khuzami came to the Commission vowing to obtain more, and bigger settlements. Khuzami has won lots of settlements – and headlines. But the willy-nilly settling of every fraud case has gotten to the point where, far from preventing fraud or punishing crime, the government has become a partner in the questionable dealings of the world’s largest financial institutions.

Where’s the political will to force change? Look at another recent example and cringe.

HSBC bank is the third-largest publicly-traded bank, and the sixth-largest public company in the world (Forbes, 2012.) The bank recently agreed to pay a $1.9 billion fine and acknowledged that for years it permitted “narcotics traffickers and others to launder millions of dollars” throughout its global system. “Millions” is an understatement.

The Justice Department says HSBC took in more than $ 15 billion in unexplained cash deposits “in Mexico, Russia and other countries. In some branches the boxzes of cash being deposited were so big the tellets’ windows had to be enlarged” (The Guardian, 14 December 2012, “HSBC Money Laundering Fine.”) Entities for which HSBC is reported to have laundered funds include Colombian and Mexican drug gangs, and the Iranian Revolutionary Guard – the backers of Hezbollah (see our Screed of 23 July 2012, “50,000 Dead Mexicans Can’t Be Wrong.”)

The $ 1.9 billion settlement represents about 25% of HSBC’s annual profits, so it will have little effect on the bank’s operation. Senior HSBC executives said they were “profoundly sorry.”

There is a high likelihood that HSBC’s money laundering activities were implicated in the murder of US citizens. Mexican and Colombian drug gangs have killed tens of thousands of Mexicans and Colombians, but they also kill US citizens. Since the drug money in question originated in street sales in the US, there is an inevitable link, not merely to the killing of the odd DEA agent or border

police officer – and not only to Mexican-American gang members in Los Angeles – but to street violence here at home. We wonder why the politicians who are challenging the President’s drone memo are not calling for harsh measures against HSBC.

Oh – silly us! Now we remember.

Assistant US attorney general Lanny Breuer said the consequences of criminally prosecuting HSBC would be “dire” – it would cost jobs and risked destabilizing the global banking system.

As to the jobs issue, we are confident the FDIC could figure out a way to keep HSBC’s domestic US business humming – a perfect opportunity to bring Sheila Bair back as Treasury Secretary. As to the global piece, we are not sure how the government defines “destabilize,” when the global banking system is already the prime conduit for funneling cash to Iranian-funded terrorists and Mexican drug lords. This is no doubt a highly specialized use of the term, a degree of nuance known only to legal minds on the level of Mr. Breuer’s. What practitioners call “a term of art.” Where’s the political will to do something about failures in the system?

In 1998, Citigroup sprang whole into glorious, robust life, born from the mind of Sanford Weill like Botticelli’s Venus. It was ably midwived by Alan Greenspan and Robert Rubin, while the slap that started it breathing was administered by President Clinton. This entailed revoking the Glass Steagall Act and ultimately led to the Commodity Futures Modernization Act, making it illegal for the government to regulate the futures markets. It’s been Off To The Races ever since.

The judicial economy argument for settling cases is to keep court resources available for really important matters. Under this rubric, there can be no more important use of judicial resources than to determine whether Citigroup committed financial fraud. This is the entity for which major laws were uprooted, new laws brought into existence, and the entire structure of the marketplace and the economy turned on its head. The Citi case is a veritable laboratory of 21st-Century American Capitalism. The transaction that laid the foundation for the contemporary financial marketplace – and for the crisis that continues to plague us.

We say America is entitled to the full story on Citi. A full hearing should determine whether such an entity should – or even can – exist; whether it is possible to implement sufficient internal controls; how such an entity should be regulated – or whether it is ultimately not possible to oversee a marketplace dominated by behemoths. It would also reveal weaknesses in the current regulatory regime and help create a roadmap to restructuring the SEC. No wonder the unholy alliance of Citi and the SEC are desperate for a court-ordered stay.

Folks, it doesn’t get more important than this.

A strong decision in favor of Judge Rakoff will lay the groundwork for the incoming SEC chairman to get serious about restoring credibility to the markets, and should send the same signal to Congress. A decision against Judge Rakoff will be clear abdication – the regulatory equivalent of the Lehman bankruptcy.

Our lawyer friends think we’re overreacting. They say it will be tough to convince a court to push back against a federal judge. We hope they’re right. Until then, we seek in vain for a policy of Zero Tolerance.


In an effort to evaluate performance and as a follow up to our YouTube, we compare how the quarter measured up to previous management commentary and guidance



OVERALL:  WORSE: While Hyatt remains focused on managing their business for the long term, the weak margins on owned and leased, and sluggish international results were a little disappointing




  • SAME:  Hyatt feels the US will have a good year while some international markets like Baku, India, and select Chinese cities will continue to be under pressure due to supply absorption, renovations, and macro issues.  Overall, there will be more volatility in the 1st half of 2013. Hyatt does believe that the current lodging cycle will last another several several years
  • PREVIOUSLY:  "In the coming quarter and then into early 2013, we're likely to see a carryover of the same type of issues that we saw in the third quarter... We do think that there are some signs of a more modest overall growth trajectory. Longer term, we continue to feel very confident about the strength of our brands and about the prospects for the industry."


  • SAME:  Large hotels in Washington, DC and San Diego, and large Grand Hyatt hotels in Asia will comprise the major renovations in 2013. 
  • PREVIOUSLY:  “Fee growth will be negatively affected in the short-term by ongoing renovations at large managed hotels, notably in the fourth quarter we expect the Grand Hyatt, San Diego, the Grand Hyatt and Hyatt Regency hotels in Washington, D.C., and the Hyatt Regency Dallas to be under renovation. As we look to next year, several of our large Grand Hyatt hotels in gateway cities in the Asia-Pacific region are planning renovations. These renovations are great for our brand presence and for our guests and for the owners over the long term, but do lead to short-term impact on RevPAR and fees."


  • BETTER:  Hotel Nikko earned over $10MM in adjusted EBITDA from May-December, ahead of its $8-10MM guidance.  Hyatt expects +$20MM in adjusted EBITDA in 2013. 
  • PREVIOUSLY:  "The Hotel Nikko acquisition in Mexico City which we acquired and rebranded as the Hyatt Regency in Mexico City this past May is performing well.  We're on track to begin renovations to this property next year."


  • BETTER:  During 4Q, Hyatt approximately $101MM of stock, which is more than they've repurchased all year.
  • PREVIOUSLY:  “We've approximately $131 million remaining under our authorization. We remained committed to a balanced strategy of investing in growth and also returning cash to shareholders when appropriate."


  • SAME:  SG&A guidance of $305MM for 2013 is close to adjusted 2012 SG&A of $303MM.
  • PREVIOUSLY:  "We expect the realignment savings to continue into 2013, partially offset by wage and other cost inflation, and the selected increase in resources as we allocate some resources towards growth initiatives. Overall, we expect the net impact to result in sort of a flattish SG&A growth in 2013."


  • BETTER:  Up 4% in 2013 (half rate/half occup), compared with 'very low single-digit' growth in 3Q. Technology, retail, and manufacturing were the strongest groups.  December bookings were the best they've seen since 2007 and January momentum was also good.
  • PREVIOUSLY:  "In the third quarter and heading into fourth quarter, definitely a slowdown in the rate of growth in group bookings for corporate customers. And I think a lot of that has to do with uncertainty due to the fiscal cliff, the election and the like. Government business was particularly weak, it was down in the third quarter for us significantly, so if you look at our third quarter results we had a slight decline in room nights for group bookings for the quarter. More than a 100% of that decline was derived from government business. Part of that is demand and part of it was yield-management decisions that we undertook to actually trade away from some of that business, so some unusual short-term impacts from the government side."


  • SAME:  Beginning to lengthen, but still seeing a barbell booking pattern between short term corporate bookings in a 90 day window and association business out a year or 2. 
  • PREVIOUSLY:  "We have a bit of a barbell going on in the sense of very different dynamics, short term among corporate groups and longer term among associations."


  • LITTLE WORSE:  Despite a solid January, oversupply and austerity measures will pressure China performance. They anticipate that some of this will ease as the year progresses
  • PREVIOUSLY:  "RevPAR performance is expected to be weaker in China given the political changes. In addition, Beijing has seen a drop in corporate business which has been postponed until after the elections. We've seen a tightening of government spending, particularly in the south of China. Once the election is over, we anticipate corporate demand will return to more normalized levels."


  • SAME:  Continued weakness seen in various India markets.
  • PREVIOUSLY:  "India RevPAR was also weak due to additional supply and the decrease in demand as a result of slowing economic growth. Most markets are not expected to see a rate increase as a result of the increased supply, near term, such as Mumbai and Delhi."


Weak owned and leased margins and international headwinds produce an uninspiring quarter


“Looking ahead, we are focused on growing our market share, increasing owned and leased margins, improving results at recently renovated and newly acquired hotels, and continuing to support expansion of our brand presence around the world. We expect that there will be headwinds in some markets, but given our concentration of earnings in the U.S., and the diversity of our business model, we look forward to a year of stable growth"


- Mark S. Hoplamazian, president and chief executive officer of Hyatt Hotels Corporation




  • 4Q demonstrated strength in some areas and challenges in others
  • RevPAR outside the US was more muted and varied.  Market specific factors, non-recurring events (China gov't transition), and difficult comps negatively impacted the Q
  • 9 hotels will be converted to their management by mid-2013 in Europe, including 4 in France. 
  • Host JV marks their first new investment in timeshare in the last several years 
  • Anticipating several more years of growth in the lodging cycle
  • Invested ~$250MM in hotels developments this year that will help grow their management fees over the next few years
  • Anticipated earning low teens returns on their New Orleans hotel but now think it will be in the high teens
  • Cash on Cash yield is already over 10% on the California assets they had acquired (they had expected 10%).
  • On Lodgeworks, they earned $45MM net of overhead in EBITDA, better than their expectation
  • Earned over $10MM in EBITDA and expect over 2x that in 2013 on Hyatt Regency Mexico City  
  • Hyatt Birmingham in England - think that they can exceed $5MM in EBITDA in 2013 which is what they originally underwrote. 
  • Group pace for 2013 is up about 4%. December was their busiest group production month since 2007 and January was good as well.  40% of the group production in January was for the next 90 days.  The booking window is beginning to lengthen although close-in bookings still account for a large portion.
  • ADRs are still below prior peak levels in nominal levels
  • Renovated hotels will provide them outsized growth in RevPAR in the future
  • Expect a margin impact from the renovation of hotels, some new supply growth in certain international markets like Baku, high insurance growth, lower F&B growth...expect more impact in the beginning of the year and think it will lessen as the year progresses
  • They are marketing a portfolio of 6 US hotels that generate $25MM of EBITDA.  If they sell the assets, they will maintain management contracts. 
  • Plan to make acquisitions as well and JV investments in the US, Latin America and Europe.  Looking to put over $100MM in these types of projects. The market is more active than what it was before.
  • Their focus is to invest in gateway cities to increase their presence but are open to other types of investments.  The acquisiton of Hyatt Birmingham for less than 9x EBITDA is a good example. 


  • Why are comparable hotel margins down in light of the good RevPAR growth?
    • Non-operating items like insurance and taxes impacted margins by 200bps, about 50% of which is non-recurring.  Excluding these items, margins would have been flat
    • F&B spend is also weak as groups are still cautious on what they spend
    • Also faced tough comps from last year
    • If you look at CostPAR, its been flat since 2007.  So they have found enough productivity measure to maintain flat costs for their full service hotels. For select service, their CostPAR has actually declined.
    • That said, there will be volatility Q to Q but more stable results over the course of the year
  • Are large groups the weakest segment of group?
    • Seeing strength in tech, retail, and manufactoring sectors
    • January is up 7% in bookings relative to last year
  • The net impact of Sandy was negligible
  • EMEA - growth ex bad debt would have been 50% less of a decline. The recovery was $2MM.
  • Why don't they pay dividends?
    • Think about their capital as a means to grow their business as their first objective
    • Have project capex commitments of over $500MM to be deployed over the next few years
    • They did repurchase stock in 2011 and 2012
    • They will consider all forms of capital returns to shareholders
  • Repurchase activity is opportunistic
  • IRR threshold varies depending on the form of the investment and project type/location.  Make sure that investments are good on a risk/reward basis and increasing their presence in key markets.
  • Expect to make $100-120MM of JV projects
  • $550MM of JV debt
  • Class B shares are not only owned by Pritzer shareholders, including Goldman.  Have 2 Pritzers on their Board of 12 members. The Pritzer family members do not have any access to information that other Board members don't have and non-board members have the same information as all other shareholders.
  • Continue to focus on SG&A and margin improvements
  • Openings this year should be 50/50 between US/international and 2/3 should be managed
  • Mid-summer 2013 for the opening of their Grand Wailea property- 2 Q's behind schedule - they changed the composition of rooms and suites and started selling residentials.
  • Park Hyatt NY should open in 2Q14
  • Why were incentive management fees down in 4Q?
    • Weaker results in certain international markets
    • Renovations in their managed portfolio
    • Continued bumpiness in 2013 to be expected
  • Slowdown in capex corresponds to the fact that their owned hotel renovations are substantially complete; hence, the slowdown in 2013.  Maintenance remains at 5% of revenues.
  • Birmingham - purchased at 50% of replacement cost.  Only have 3 properties in all of the UK.  Lots of group activity at that hotel. The hotel was in receivership when they bought it. Want to control their presence in that market.
  • Expect continued issues in Baku and India. Some markets in China have oversupply as well. 
  • They are seeing more of a barbell distribution on the short end of the booking end and also a year or 2 out - largely associations. 
  • Group strength is in the smaller meeting sizes and smaller groups. Large groups are lagging.
  • Demand in NY is holding up quite well despite supply growth
  • Given the Sandy premiums coming through, it's likely that insurance premiums will continue to rise
  • The insurance amounts had a true up in the Q 
  • December was one of the best Decembers that they've had since 2007. They do feel better about group now than last Q
  • While the booking window is lengthening, they still see a major amount of activity for the next 90 days.
  • Have had a more pronounced drop in government business on the group side



  • 4Q highlights:
    • Adjusted EBITDA of $147MM and adjusted EPS of $0.20
    • Comparable owned and leased hotel RevPAR increased 7.5%
      • "Benefited from solid demand and to a limited extent from renovations completed in prior periods"
    • Owned and leased hotel operating margins decreased 10bps
    • Comparable U.S. full service hotel RevPAR increased 5.8%
    • 6 properties opened
    • Repurchased 2,779,038 shares of Class A stock at a weighted average price of $36.34 per share, for approximately $101 million
  • Expect to open over 30 hotels in 2013, including the conversion of four iconic hotels in Paris, Nice and Cannes to Hyatt brands
    • ~1,700 rooms, "more than double our presence in France and is a meaningful expansion of our coverage in continental Europe"
  • "Revenue for comparable owned and leased hotels was negatively impacted by weak performance in certain international markets and lower relative growth in non-room revenue at U.S. hotels"
  • "Excluding expenses related to benefit programs funded through rabbi trusts and non-comparable hotel expenses, expenses increased 4.3% ....Comparable expenses were negatively impacted by insurance costs."
  • Changes to the owned & leased portfolio in 4Q:
    • Hyatt Regency Birmingham (owned, 319 rooms): $43MM purchase price
    • Andaz Amsterdam (leased, 122 rooms)
    • Closed on the sale of 8 select service hotels (1,043 rooms) for approximately $87MM and will continue to manage these hotels under long-term agreements.
  • Americas Mgmt & Franchise segment:
    • Group rooms revenue at comparable U.S. full service hotels increased 3.3%. Group room nights increased 0.4% and group ADR increased 2.9%
    • Transient rooms revenue at comparable U.S. full service hotels increased 6.9%. Transient
      room nights increased 2.1% and transient ADR increased 4.7%
    • Portfolio changes in the Q:
      • LA Hotel Downtown (franchised, 469 rooms): This property is expected to be rebranded Hyatt Regency Los Angeles Downtown upon completion of a renovation
      • Hyatt Place Los Angeles/LAX/El Segundo (franchised, 143 rooms)
      • Hyatt Place San Jose/Pinares (managed, 120 rooms)
      • 3 properties were removed
  • Southeast Asia, China, Australia, South Korea and Japan (ASPAC) Mgmt and Franchising Segment:
    • Adjusted EBITDA increased 7.1%
    • RevPAR for comparable ASPAC hotels increased 3.1% (2.9% excluding the effect of currency)
    • Revenue from management and franchise fees was flat
    • 1 property was removed
  • Europe, Africa, Middle East and Southwest Asia (EAME/SW Asia) Management Segment
    • Adjusted EBITDA decreased 36.4, impacted by a bad debt recovery in the fourth quarter of 2011
    • RevPAR decreased 0.8% (increased 1.1% excluding the effect of currency), "negatively impacted by lower performance in markets in the Middle East and in Gulf Cooperation Council countries"
    • Revenue from management and franchise fees decreased 5.3% 
    • Additions: Park Hyatt Chennai (managed, 201 rooms); Andaz Amsterdam (leased, 122 rooms); Hyatt Place Hampi (managed, 115 rooms)
  • Adjusted selling, general, and administrative expenses decreased by 2.6%
  • "As of December 31, 2012 this effort was underscored by executed management or franchise contracts for approximately 200 hotels (or approximately 45,000 rooms) across all brands"
  • Capex of $91MM: Maintenance ($42MM); Enhancements ($39MM); Investment ($10MM)
  • From January 1 - February 8, Hyatt repurchased 12,123 shares of Class A common stock at a weighted average price of $37.95 per share, for approximately $0.5MM. "The Company has approximately $63 million remaining under its current share repurchase authorization."
  • In 4Q, Hyatt "formed a joint venture with Host Hotels & Resorts to develop and operate a Hyatt Residence Club in Maui, Hawaii. The Company expects to invest approximately $40 million in the vacation ownership property"
  • "Subsequent to the end of the quarter, the Company closed on the sale of three select service hotels, with an aggregate of 426 rooms, for approximately $36 million"
  • Total Debt: $1.2BN, Cash: $413MM and short-term investments of $514MM
  • 2013 guidance: 
    • Adjusted SG&A: $305MM
    • Capex: "$300 million, including approximately $120 million for investment in new properties, such as Grand Hyatt Rio de Janeiro, Hyatt Place Omaha and other properties"
    • D&A: $340MM
    • Interest expense: $70MM

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Slouching Towards Wall Street: When Standards Are Poor

When Standards Are Poor

In December 2001, Richard Reid tried to blow up an American Airlines international flight by igniting explosives in his shoes. The FAA immediately swung into action and in short order all departing passengers had to remove their shoes for security screening.

On Christmas Day 2009, Umar Farouk Abdulmutallab tried to blow up an international flight using explosives packed in his underwear. This did not lead to passengers having to remove their underwear – though it but did give rise to the expression “Don’t touch my junk!” which enjoyed its own fifteen minutes of fame.

No one has since been threatened by shoe bombs or knicker bombs. The authorities would have us feel reassured at what a good job they are doing, while skeptics observe that all we have done is protect ourselves against yesterday’s threats.
In the sorry tale of AAA-rated CDOs, we are not sure which is worse: the idea that the ratings agencies may have been criminally negligent in assigning AAA ratings to toxic investments, or the fact that the government was nowhere to be seen when the disaster was a-building, but is here with a multi billion-dollar shakedown after the fact. However you view it, the authorities are making S&P go through the equivalent of removing their shoes at security, almost a decade after they failed to curtail the rating firms’ contribution to the biggest financial disaster in a century.

The courts have generally agreed with the ratings agencies’ position that what they publish is independent journalism and protected by the First Amendment. We find this disheartening, as well as incomprehensible rubbish. Meanwhile, the Department of Justice complaint against S&P says financial institutions relied on credit ratings “to identify and compare risks” among various instruments. This is also misleading and we think we know why.

Financial institutions are required by SEC rules to purchase investment-grade rated investments. Portfolio managers are also mindful of the high utility of AAA ratings in defending poor performance. It is less a question of portfolio risk – would that the average portfolio manager could recognize a credit risk if he tripped over it! – than of career risk: the government mandated CYA factor allows portfolio managers to sleep soundly at night, safe from the threat of both regulators and plaintiffs’ counsel, even as the value of the assets they manage dribbles away. The government does not want to out itself as the prime suspect in its own case, which is why the Complaint says the firms used ratings “to identify and compare risks,” rather than for their actual purpose as a government sanction to reduce their cash reserves.

Warren Buffett chuckled when Congress quizzed him about his investment in Moody’s. The government has guaranteed the rating firms a monopoly, he said, why wouldn’t you invest? We are not sure whether Buffett chuckled because he couldn’t believe Congress did not realize they were the very guarantors of that monopoly, or because he was tickled that they were all in on the joke together.

“Ratings agencies.” The SEC is an “agency.” The DEA is an “agency.” The Secret Service and the CIA are “agencies.” Calling the rating firms “agencies” implies they are an arm of the government. Under a decades-old bargain with Wall Street, the SEC designates these firms as NRSROs – Nationally Recognized Statistical Rating Organizations – and requires financial institutions to buy debt that is rated investment grade, giving the NRSROs regulatory standing. The SEC website says ( “A credit rating agency is a firm that provides its opinion…” How can the SEC discipline the raters when the Commission’s own definition accepts the First Amendment argument? This looks like a textbook definition of Regulatory Capture.

John Moody first published basic industry statistics in 1900. In 1909, Moody’s analysis of railroad investments was added to “Moody’s Manual” and an industry was born. Until the 1970s the raters made their money selling subscriptions to investors. The industry converted to the issuer-pays model on the theory that a broad payer base enables firms to take on full-time staff and perform a full modeling on a large number of issues, making it economically more efficient than the subscription model. No one mentioned the potential for conflict of interest.

In 1975, the SEC permitted banks and brokerage firms to reduce their regulatory capital reserve burden. The SEC designated certain raters NRSROs and eased requirements for portfolios holding investment grade paper. As long as most bonds looked the same, most of the raters’ models held up very well. The default rate in investment grade paper was miniscule. The system worked.

Today, even after the massive failure of rating the exotic instruments of the past decade, the biggest value of the major rating firms is their massive databases. Moody’s Investor Services has been gathering and analyzing data on a broad range of industries since 1914. Their bond models are based on a century’s worth of data and modeling experience, and the imposition of the NRSROs’ models as the standard has caused bond issuers to conform to structures the raters find acceptable.

What happened in the recent meltdown was largely attributable to two problems. First, the raters’ standard models did not apply to the new-fangled synthetic instruments being created and traded like so many hotcakes.

Debt analysts work from established models. They determine what kind of debt an issue represents, then plug in the numbers and run it against their historical database. This works very well – except when it doesn’t. In the CDO debacle, the analysts were largely using their standard models, and coming up with results that proved disastrous. Imagine taking your French traveler’s phrase book and trying to talk your way out of a drug bust in Mongolia.

Unlike analysts who write company research for stock investors, bond analysts don’t go out into the field. They rely on information from issuers. The rating firm analysts didn’t determine whether anyone was actually living in the homes that secured the residential mortgage-backed securities (RMBS – one of the categories mentioned in the DoJ complaint.) Their models were not structured to reflect the risk that a pool of mortgages might include million dollar homes bought with no money down by window washers earning $18,000 annually.

The second problem may seem surprising. It appears the competition for high-ticket business drove a frantic race to the bottom among the NRSROs. A recent paper from the London School of Economics

( concludes “relative to monopoly, rating agencies are more likely to inflate ratings under competition, resulting in lower expected welfare.” The authors find the lowering of standards was driven not by the banks pressuring the raters to inflate ratings, but by the rating firms themselves who focused on “the trade-off between maintaining reputation (to increase profits in the future) and inflating ratings today (to increase current profits.)” The rating agencies needed no prodding to act in bad faith. They were induced not by greedy bankers, but by the unfettered operation of the free market. The authors cite a range of academic work that concludes the issuer-pay model leads to inflated ratings in a competitive scenario.

The statistics are shocking – one wonders why no one was shocked at the time. “According to Fitch Ratings (2007), around 60% of all global structured products were AAA-rated, compared to less than 1% for corporate and financial issues.” How can a majority of a category be ranked “superior”? After an unprecedented jump in defaults the rating firms “lowered the credit ratings on structured products widely, indicating that the initial ratings were likely inaccurate.” The Complaint describes the panic that gripped the CDO markets in 2007 once S&P was forced by reality to start issuing downgrades.
The DoJ points to divergent assumptions: the ratings departments consistently were more upbeat on Collateralized Debt Obligations (CDOs) than were the compliance departments of the same rating firms. In the event, even those cautious assessments proved wildly optimistic, which would not have mattered anyway, as “signals from the surveillance department were ignored.”

The DoJ case appears to rest on a novel legal theory. Under the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA) Justice accuses S&P of defrauding a federally insured institution, thereby defrauding the taxpayer. The government also accuses S&P of favoring the issuing banks in order to increase market share (the conclusion of the LSE paper) and alleges “S&P

falsely represented to investors that its ratings were objective, independent and uninfluenced by conflicts of interest.”
A number of internal S&P emails have been reprinted in the media. “Subprime is boiling over. Bringing down the house,” wrote one S&P-er to a colleague. Another chortled a CDO “could be structured by cows and we would rate it.” But these are mere fluff compared to internal communications the press have not reprinted, such as repeated messages from one executive showing that over 50% of transactions in one AAA product had severely delinquent loans and had already experienced a number of defaults compromising 25% of the credit underpinning the RMBS. This executive expressed frustration that senior S&P officials prevented her from downgrading subprime RMBS because of the negative impact it would have on S&P’s business.

In 2004 one executive objected vehemently to proposed “market insight” and “rating implications” practices, asking what the reaction of the market has to do “with the search for the truth.” “Are you implying,” asked the executive “that we might actually reject or stifle ‘superior analytics’ for market considerations?” The executive references the political fallout when S&P tried to publish revised Predatory Lending Criteria, acknowledging the firm was under significant pressure to be less forthright in announcing the truth, and saying the firm must retain its integrity. The email was never responded to and the new market-friendly procedures were adopted.

The Justice Department seems to argue that S&P bamboozled major financial institutions into issuing toxic mortgage-backed securities, implying that they would not have issued tens of billions of dollars’ worth of bad paper if S&P had alerted them to risks in the portfolios. This appears facetious, but the NRSROs are supposed to act as gatekeepers to the system, and are so designated by the SEC. Warren Buffett testified before Congress in the heat of the financial crisis that he didn’t blame the rating agencies for missing the risks in the market, since everyone else missed them too. Oh really? Would you buy a used AAA rating from this man? Buffett, whose job as an investor is to figure out risks and opportunities no one else sees, was not troubled that the firms whose job is to identify risks that no one else sees were not capable of identifying those risks. Where does the buck stop?

The DoJ Complaint, though sobering reading, may lead nowhere. The DoJ does not seek to prevent the courts from agreeing that the raters are mere journalists voicing an opinion, nor to impose any greater duty of care on portfolio managers and institutions when buying AAA-rated paper, nor to strengthen the SEC and its oversight of the raters. It will require tightened internal standards at the NRSROs, but the real outcome is likely to be an industry-wide ban on ever putting anything in writing, rather than any Road To Damascus rethink of the business model.

The Complaint names a number of S&P executives with significant decision making authority, including the authority to override analyst ratings and slap a higher rating on an instrument. But while they are shown making key calls at the core of the crisis, no redress is sought from these executives. The only entity charged with committing fraud, or any wrongdoing, is “S&P.” This reminds us of the signs waved in protest at the Citizens United Supreme Court decision: “I’ll Believe A Corporation Is A Person When Texas Executes One.”

In settling major fraud cases, regulators routinely take senior management aside and suggest it might be smart to allow such folks to resign. Allowing them to head off to other firms may be the right thing to do, or it may be the equivalent of jailing the rifle while freeing the murderer. Since the Complaint does not charge individuals we may never find out the nature of these executives’ acts or the extent of their influence.

Critics complain that, 2 ½ years after Dodd Frank, the SEC still has not promulgated new rules covering the NRSROs. While we have no excess fondness for the Commission, it has not so much fallen down on the job, as it has been tripped by members of Congress only too happy to see even the feeble SEC regime grind to a halt.

We think the likely outcome is a high-priced settlement, not a conviction. We don’t believe the DoJ wants to go to trial. The presence of those pesky emails probably makes this case juicy bait in their eyes, but they have to be aware of how difficult it will be to prove that S&P corporation acted with prior intent to defraud.

We think it is clear that the NRSROs were negligent, in that they used tried and true models for completely new market structures, ones which not even the folks creating them really understood. They added 2 apples and 3 apples and came up with 5 oranges – and never thought to question the result. After all, the numbers worked.

And we accept the obvious power of market forces. Ratings are a commodity. S&P does not have a perceptible edge on Moody’s in terms of database or the brilliance of its analysts. It can only really compete on the basis of offering more for less, which should have been obvious to regulators, Congress, investors, issuers… coulda, woulda, shoulda.

Once this is over, we think S&P will go back to doing what it has always done best: providing decent employment for highly unremarkable business school grads – folks who learn to crunch the numbers but who don’t have what it takes to make it on Wall Street. They will continue to build and to apply their century-old troves of data, though on occasion an analyst may actually go on-site to determine whether assets pledged to secure a bond issue actually exist.

S&P employees will be given rigorous training around the use of various forms of electronic communication. The rating firms will hire additional compliance personnel, not to oversee the process of issuing ratings, but to make sure no one is sending emails about it.

Business will, in short, return to Usual. The DoJ will cash a big check and pat itself generously on the back. And just as we are now safe from shoe bombers on airplanes, we will be protected from the risks in subprime-backed RMBS. We have seen the self correcting process of the Invisible Hand in the financial markets before, and it is gratifying to know it works so well. When was the last time you heard of someone losing their entire fortune in tulip bulbs?

A Sad Milestone For Press Freedom

The organization Reporters Without Borders calls 2012 the worst year on record for journalists. Ninety working journalists and 48 bloggers were murdered last year, according to the NGO. Worldwide, nearly 300 journalists were detained, and a number of others were exiled, had their work censored, or were threatened. High on the list of problems are the violence in Syria, the chaos in Somalia, and the activity of the Taliban in Pakistan. The group says hopes raised by the “Arab spring” have crumbled as bloggers are persecuted across the Arab world. But the worst place on earth for journalists in 2012 was Somalia, where 18 journalists were shot and decapitated. The organization also expressed its concern over companies such as Google bowing to pressure from various governments, with the result that now only one in four persons has access to the internet. A Google director says web censorship is in place in 40 countries and that Google is subject to government pressure in more than 30 countries.

The organization highlighted Turkey where, despite formally implementing a press freedom policy – a pre-condition for EU membership – at least 75 journalists are currently detained, and 125 are defendants in cases brought by the government. Investigative journalist Nedim Sener, writing in leading Istanbul newspaper Milliyet, calls Turkey “the world’s largest prison” for journalists, claiming that over 200 journalists currently working in Turkey have been detained at some point in their careers, often on charge of associating with terrorist organizations. It is difficult to report the news when interviewing someone makes you a suspect in their activities.

#HousingsHammer: Don’t Be Fooled by This Morning’s Print


Expectations for continued improvement in the domestic housing market - a theme we've dubbed #HousingsHammer - remains a 1Q13 Macro Investment theme we continue to like.  Superficially, this morning’s -10% print in the MBA Purchase Index would appear to signal a change in trend and a notable drop off in demand. 


However, an analysis of the historical seasonal pattern for February in conjunction with the trajectory of the broader, rolling 4wk and 1Q13 YTD growth trend suggest this week’s steep decline represents a poor reflection of underlying demand.  


Below is a more detailed analysis of this morning’s MBA Mortgage Application release from our Head of Financials (and all things Housing Related) Josh Steiner.  Email if you would like to trial Josh’s work.   



Don't Be Fooled By This Morning's Weak Print

This morning's print from the MBA certainly got our attention, as the purchase index was reportedly down 10.0% week-over-week, reversing a string of positive progress since the start of the year. Did demand to buy houses really drop 10%? We don't think so.


There are a couple ways to approach this, but the simplest are to consider whether there was an inflection in the year-over-year rate of change, and there was virtually none. This past week was up 20.5% vs. the prior year, which compares with the YoY growth over the preceding three weeks of: 22.6%, 20.3% and 20.7%. In other words, the weakness seems to be stemming from a recurrent seasonal adjustment distortion and not from a bona fide decline in demand. This is backed up by looking at WoW change for this past week in prior years. In 2012, this week was down by -8.4%, which was then recovered shortly thereafter. In 2011, this week was down by -5.9%, which was recovered in the following week. In 2010, it was down -7.0%, which was again shortly thereafter recovered. As such, we would certainly expect to see purchase demand bounce back in the weeks ahead.


Taking a bigger picture view, as we mentioned above, the last four weeks of purchase data have been growing at an average rate of +21.0% YoY. On a 1Q13TD basis, the volume is up 16.5% vs. 1Q12, and continues the streak of 5 consecutive quarters of sequential YoY growth acceleration. There is little doubt, at least to us, that mortgage purchase demand remains strong and continues to accelerate.


Our bullish thesis on housing continues to revolve around price and the idea that housing is a Giffen good. As prices rise, consumers buy more of housing and vice versa. The empirical evidence bears this out. This is also at the heart of why housing trends tend to be autocorrelated. Rising prices beget growing demand, which, in turn, reinforce further price increases and so on. So long as we see demand rising, which it is, our bullish thesis on housing remains intact.


Refi Continues to Cool

Refinancing activity, not surprisingly, continues to cool down vs. its recent 3Q12 peak as rates continue to creep higher. Refi volume was down 6.0% week-over-week, which brings the index level to 3,887. This compares with the 1Q13TD average of 4,009 and the 4Q12 average of 4,345 (3Q12 was 4,533). 1Q13TD is still 9% higher than 1Q12 levels of activity, but on a QoQ basis, it's down 8%. 


Rates on 30-year fixed conforming loans have backed up from lows in the 3.4% range throughout 4Q12 to 3.64% today based on the Bankrate index. Using the contract interest rate provided by the MBA, rates have risen to 3.75%, up 2 bps WoW and up in 8 of the last 9 weeks.


The outlook for refi activity is clouded by two big unknowns. First, rates appear to be headed slowly but steadily higher. This is putting obvious pressure on activity levels. Second, President Obama would like to roll out underwater refinancing availability to non-GSE borrowers (HARP 3.0), though this remains more of a proposal than a probable event at this point. 


Taken together, the purchase and refi activity, overall mortgage activity is tracking +8.3% YoY thus far in the first quarter and down -5% vs. 4Q12.


Joshua Steiner, CFA


#HousingsHammer: Don’t Be Fooled by This Morning’s Print - JS 1 yoy shark


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Two potentially big developments in Gaming Supply




Late yesterday, we began hearing from a few of our slot manager contacts that 2 weeks ago, IGT began offering price discounts to all of its customers.  The discounts apply only to for sale games and do not extend to IGT’s participation products.  So far WMS & BYI are not matching, but they are calling their customers and scrambling for a response.  We believe that IGT’s aggression could pressure an already flat industry pricing environment.  


It is our understanding that the discounts extend to the end of September – the end of IGT’s fiscal year.  There is some speculation in the slot community that IGT is just trying to boost its ship share and produce another big quarter with the Ader Group proxy fight under way but that wouldn’t completely explain the longer discount duration.  We believe that the main goal of this program is to try and spur a replacement cycle on their video poker platform and S2000 (mechanical spinning reels) by offering very aggressive pricing, especially to bulk purchasers.  IGT dominates both the reel-spinning and video poker categories so that could mitigate the reaction from competitors.  The discounts in the most competitive segment – video (not poker) – were much less aggressive.


This is a bold move on IGT’s part and somewhat risky if the other players match IGT’s aggression.  However, replacement demand, while improving, is still at depressed levels and could use a spark, especially in reel-spinning and video poker, where IGT was most aggressive with the discounts. 


Here are some of the details from their program:

  • For ~10 machines:$500 off; >11-25 machines: $1,000 off, >26-50 machines: $1,750 off
  • Additional discount if you take delivery by June 28th
  • Very aggressive pricing on the S-AVP (mechanical reel) meant as a replacement to S2000
  • Very aggressive pricing on video poker (G20 & bar top version) 
  • Universal Slant with MLD has a hefty discount or a lower discount with a heavy trade-in credit



Switching gears, our research has turned up a potentially large opportunity for the gaming suppliers.  Apparently, the Oregon Lottery is considering submitting an RFP to refresh its all the units in its 20,000 VLT market.  This would be a series of very big orders that would meaningfully impact earnings of IGT, BYI, and WMS.  


Daily Trading Ranges

20 Proprietary Risk Ranges

Daily Trading Ranges is designed to help you understand where you’re buying and selling within the risk range and help you make better sales at the top end of the range and purchases at the low end.