Are the Rating Agencies Going Away?

Discussion in 'Trading' started by livevol_ophir, May 10, 2010.

  1. livevol_ophir

    livevol_ophir ET Sponsor

    Details, trades, vols, skews, analysis, prices here:

    MHP is trading 28.19, down 6.9% with IV30&#8482 up 6.4%. MCO is trading $20.81, down 10.9% with IV30&#8482 up 12%. All this while the broad market is absolutely on fire - up more 4%.

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    The first blog (5-4-2010) on MHP:<b><a href="">Click Here to Read</a></b>. I love Warren Buffet's comment...

    At the time, MHP had some bearish order flow, increasing vol and an ugly looking chart. The summary from 5-4-2010 is below.

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    You can see the stock is lower by more than $4 and vol is up more than 11 points in just those 6 calendar days.

    I mused in the prior blog that the rating agencies tend to skate free from the allegations (i.e. facts) that they give whatever rating necessary to the big banks garbage as long as it keeps the the dollars flowing. Several insiders/analysts have come out to air the dirty laundry. It seems this time, the agencies might actually have to pay the piper.

    Quick Snip from an article by Brooke Masters (<a href="">Read it Here</a>):
    Moody’s revealed last week that US regulators want to bring charges against it, and judges have now allowed four separate investor lawsuits against the rating agencies into the evidence gathering stage...

    MHP has traded over 3,775 options in the first hour on total daily average option volume of just 719. All but 796 contracts have been puts. The retail side on the ISE exchange has opened 661 long puts relative to a single call (ISE Sentiment). The Stats Tab and Day's biggest trades snapshots are included (<a href="">in the article</a>).

    The Options Tab (<a href="">in the article</a>) illustrates were the action is. I note that a lot (some) of the order flow is vol selling - these are not all purchases. Also note that the vol in May AND June is lower than the vol in Aug which has the vol event (earnings).

    This occurs for a few reasons. First, it looks like there is going to be some clarity regarding the lawsuits (a lot of them) relatively soon. Also, August is in the end of summer, a notoriously dead time for the market - vol tends to dip. But still...

    The Skew Tab snap from today is included (<a href="">in the article</a>) as is the one from the prior post (<a href="">in the article</a>).

    The shapes are similar - May is clearly more pronounced now with the Moody's disclosures and the developments (see article reference above).

    Finally, the Charts Tab for MHP (6 months) is <a href="">in the article</a>. The top portion is the stock price, the bottom is the vol (IV30&#8482 - red vs HV20&#8482 - blue). The yellow shaded area at the very bottom is the IV30&#8482 vs. the HV20&#8482 vol difference.

    In the words of my friend's three year old - "Stock go bye-bye."

    <b>How to Trade This</b>
    So not too get to one sided in your thinking - and since I know you didn't read the whole article above - here are some snippets:

    "The investors’ success is extremely preliminary and could well be short-lived. Judges are usually quite deferential to plaintiffs’ claims in early motions and may prove more sceptical once the evidence is in. But the victories stand in stark contrast to the failed efforts to hold the agencies accountable in the 2001 collapse of Enron."

    "“They [plaintiffs] enjoyed sweeping deference in the courts but now you are seeing some cracks,” says James Cox, Duke University law professor."

    "The credit rating agencies argue that they are doing much better on the legal front when the broader picture is considered."

    "S&P, which provided the most detailed statistics, said that judges have thrown out 11 cases against it and five more have been dropped by the plaintiffs. Five motions to dismiss are pending and roughly 20 cases have not yet reached a stage where S&P can ask to have them thrown out."

    "“So far we have been pleased with the results and think that we are well on our way to persuading the courts to dismiss the overwhelming number of these cases,” says Floyd Abrams, an attorney for S&P. "

    "He said the company was particularly pleased that six judges so far have rejected plaintiffs’ claims that the credit rating agencies were acting as “underwriters” alongside the sponsoring banks."

    Ok, so if you're a trader the top part of the blog read as: "Blah blah blah." A few ways to trade this:

    1) If after reading the article and doing some homework you feel one of MCO/MHP is relatively worse (or better) than the other, you could pair-trade (buy one/ sell the other).

    2) If you think the worst is over - or, the vol implicit in the options is over stating the potential fall from here (these stocks are down size), sell the straddle on the strike you think the stock is going to (and please cover up somewhere else).

    3) If you think this is really just the beginning, do some juicy put spreads. The downside is super bid, you can get short delta while buying lower vol than you're selling.

    4) If you think there will be more and more delays - with uncertainty remaining high - buy August and sell the front months. 45 vol in Aug feels low compared to May and Jun. BUT, remember, this is not an "earnings" play - so it could be accurate to say that the earnings vol event is in fact lower vol than the legal vol event (i.e. the vol diff is arguably totally correct).

    5) You could buy 2 Jun 25 puts and sell 1 Aug 25 put for a credit. If the stock collapses soon you have 2 straddles to cover 1 for a premium positive trade. Of course, if this drags on past Jun, you're long 2 worthless straddles and short a jumbo vol straddle. You could also do the opposite side of this same trade...

    One argument: Everyone in powerful positions (read: "everyone that is rich and in politics") is hyper aware of market psychology. Do they really want the rating agencies to disappear - lose tens of thousands of jobs and rattle the market?

    Counter Argument: Having said that, it's possible (I guess) these stocks could halve without the market melting down. They don't have to disappear to get smashed.

    What do you guys think?

    This is trade analysis, not a recommendation.

    Details, trades, vols, skews, analysis, prices here:
  2. 1) MCO should mover faster because it's more "concentrated" as a ratings company compared to MHP which appears more diversified, something to keep in mind for pairs-trading. :cool:
    2) Any business is a good business during a bull market Warren. :mad:
    3) Do you really need thousands and thousands of "analysts" to come up with ratings? Couldn't a simple algorithm accomplish the same thing? :confused: :(
  3. livevol_ophir

    livevol_ophir ET Sponsor

    Phenomenal point!...
  4. gimp570


    MCO another masterful call by Einhorn??

    its starting to look that way
  5. Moody's sent me a "AAa+" rating for that. :D
  6. livevol_ophir

    livevol_ophir ET Sponsor

    I think that's an insult given their other AAa+ ratings... Can I re-consider :cool:
  7. OK here's a question. You determine the ratings agencies are going to get screwed. However, this was true 1 year ago also. Since then, MCO has had a 100% rally and a 66% rally. What kind of size can you short when it can rally 50-100% against you on nothing? Maybe 2%, 3%? And what's your upside, a 50% fall from here? So you are risking 1.5-3% loss on a BS rally, to go for a 1.5% gain.

    Basically if you have huge conviction and are right, you have what, a 75% chance of making 1.5% and a 25% chance of losing maybe 1.5-3%. Your expectation on this 3% risk is thus 0.5% approximately.

    A trade where your average EV is 0.5% and your max risk is 3% doesn't look too attractive to me. Am I missing something here?
  8. livevol_ophir

    livevol_ophir ET Sponsor

    I said they might get screwed. I have no idea what's going to happen.

    A year ago is not today for the agencies. With the rage over GS bubbling, I think they are in for a bit more scrutiny than ever before.

    But, maybe not... They havea license to print money, so, as Warren said, it's a good business...

    The federal requirement is at least 2 credit ratings on each public debt, and there are only 3 agencies... awesome...