Citibank vs. Moody's: Now We're Banking on Long-Term Credit Health
Finally, disparities between the opinions of investment banking analysts and credit ratings agencies are beginning to emerge. That may be one of the most underrated signs of the industry's improving health out there right now.
A recent example: Citigroup vs. Moody's
In the financial services sector recently, Citigroup analysts are getting almost as bullish as the bank's shareholders. As Citigroup's shares rose earlier this month, the bank's research department issued a flurry of upgrades on credit and financial firms.
On Monday last week, Citigroup analyst Keith Horowitz was the first on the street to upgrade Goldman Sachs to "buy" from "hold," citing the bank's potential ability "to pick up significant market share in key institutional businesses." In the same research note, Horowitz upgraded rival Morgan Stanley to "hold," and added that the bank is "a solid franchise."
Horowitz's upgrades come just a week after Citigroup gave its partial blessing to ailing credit card company American Express with an upgrade to "hold," saying that from now on, "the bear case for American Express is simply less compelling." Again, the bank cited the "franchise quality" of the lender, and increased its price target for the stock nearly 80 percent.
In the United Kingdom, Citigroup created a fanfare on the stock exchange floor the day after Horowitz's Goldman upgrade when it pinned a "buy" rating on credit trader BlueBay Asset Management. The controversial show of confidence in the fund manager sent shares in London roaring 25%. Haley Tam, the analyst responsible, said that "now is the right time for the market to start looking forward to the upswing in earnings next year."
The upgrades come at a time when ratings agencies have been particularly harsh on the financial services industry. Last week, Moody's downgraded Warren Buffett-owned Berkshire Hathaway after Fitch Ratings downgraded the company in March. Tuesday, Moody's issued another downgrade to Midwestern lender Fifth Third Bankcorp.
Those downgrades follow Moody's less optimistic verdict on the credit worthiness of American Express partner General Electric, which the ratings agency downgraded last month.
Conflict of interest, resolved
Let's hope the credit rating agencies don't follow the lead of the banks, as they have in the past. One of the major problems with the banking sector last year was the unsuitability of many of the investors holding shares in banks whose balance sheets were burgeoning with subprime and mortgage-backed security related deals. While it's OK for speculators to lose their shirts, charities and pension funds should have never been permitted to own such risky assets. Making sure this doesn't happen is Moody's job, which is to rate the risk of the asset.
In recent years credit ratings agencies -- under pressure from the clients that pay them for their ratings (who are banks such as Citigroup) -- have come to resemble equity analysts more than they have the staid bean counters they are supposed to be. That's how so many unsuitable investors ended up piling into credit securities and the shares of the banks who owned them.
It's no secret any longer that there's an inherent conflict of interest in being paid to assign a note of creditworthiness. But organizations such as Moody's are supposed to impartially asses the risk of default in the event that things go awry.
That's altogether different from the job of investment banking analysts, whose role it is to rate the stock -- and, in many cases, to help the equity salesperson get it off the bank's books fast. Furthermore, the fact that Moody's doesn't think the debt of one company is suitable for loss-sensitive investors doesn't mean that its stock isn't cheaply priced. In many cases, it means that the bank wants to unload their position in the security, and thus assigns a sell-side analyst to plump a "buy" rating on it with a convincing spin. That's all very well -- clients, after all, will stop doing business with a bank that keeps up this kind of practice consistently -- but part of the pitch should not be a note of creditworthiness from Moody's.
Problematically, this practice is most common in some of the riskiest areas of the market: underwriting. When a bank underwrites a stock, it assumes a large portion of the risk for the fees it gets for the process by agreeing to buy back any of the unsold shares in the issue. That's why an underwriting bank's analyst will often rate the IPO a "buy," such as Citigroup did in February when it took Mead Johnson Nutrition public, earning it around $16 million in fees. While every "new offer" on the market is inherently risky by the fact that it has no trading history, in the past few years the work of credit ratings agencies has effectively amounted to a doubling-up of an i-banking sales support function.
When a disparity in opinion forms between investment analysts and ratings agencies, that's generally a sign that high risk is being shipped off to corners of the market that can weather the ups-and-downs that go with it, such as hedge funds. The recent divergence in opinion is good news, because it means the right assets end up in the right hands. At the very least, it means that dubious sales practices are kept at bay.