Last Friday, April 16, Goldman Sachs was slammed down by roughly 13% from the announced SEC charges. Sure enough, options expiration also contributed to the exaggerated movement. Nonetheless, I am neither a corporate lawyer nor an investor in collateralized debt obligations, so I am forced to look beyond Goldman's case but use the news from it to help direct me to yet another opportunity that could potentially stem from the SEC and its now-active hunt, thanks to its new leadership, to catch "The Bad Guy."
With the SEC alleging that Goldman Sachs misled investors, it seems appropriate for the rating agencies to be on deck, or at least in the hole. I say that because they too arguably could have 'misled' investors. The issue with the rating agencies is nothing out of the ordinary and the ongoing debate, regarding the business model and the fact that the rating agencies profited generously while few concerns existed about mortgage-related securities prior to the crash, is soon to be refueled. Consider the following statement: "Moody's has already been criticized by lawmakers and regulators for giving top rankings to subprime-mortgage related securities that have tumbled in value as borrower defaults soar to records." -Bloomberg, May 2008
With the spotlight on Goldman Sachs for reasons that occurred a couple years ago, the time to make a move on the rating agencies is now. I worked on a quantitative model today to help me decide which company seems more shrewd to ‘bet against,’ McGraw-Hill (ticker MHP) or Moody’s (ticker MCO). Keep in mind from an investment perspective, if one’s portfolio is overweight equities on the long side, put options and short selling are unique tools, if used correctly and with thought, that can mitigate risk, potentially more than an a broad based US equity mutual fund which is still vulnerable to negative sentiment.
I looked at the January 2011 $22.50 and $17.50 put options for McGraw-Hill and Moody’s, respectively. I chose January 2011 because it can take time for the SEC to move on from Goldman and anyways, the longer the time when waiting for a catalyst, the better. The following strikes assume a near 35% decline in the two equities from their closing price on April 19th, 2010. Take the 13% decline from Goldman, round it to 15% (applying that reaction to the rating agencies if they make it to the plate) and assume another 10% for future allegations and 10% for the market correction everyone is so worried about. There you have it, 35% possible downside for the rating agencies. Also, with the VIX near its 52-week lows indicating low volatility, option prices are deemed discounted.
In conclusion to my analysis, I would go with the put options outlined above for both McGraw-Hill and Moody’s. I would go with McGraw-Hill puts because its average equity return is only .05% less than Moody’s while its option premium is roughly $.45/contract where as Moody’s is about $.84/contract (April 19, 2010 close). More importantly, they are both subject to the same potential allegations/regulations. In addition, McGraw-Hill does not have the generous backing of Buffet’s Berkshire.
Moody’s on the other hand has a 16.19% probability of having a 36.15% (≈35%) decline by January of 2011 when compared to McGraw’s 5.43% probability of having a 34.63% decline by Jan 2011. The short interest for Moody’s is 12.95% of the float relative to only 2.34% of McGraw’s float. With McGraw, that just means sophisticated investors who do agree to my point even in the slightest, have yet to make a move. For the students and others out there thinking that McGraw just publishes textbooks, for 2007, 2008, and 2009, 44.98%, 41.77%, and 43.85% of McGraw's total revenue derived from its Financial Services segment, respectively. That segment operates under the Standard and Poor's brand. All of the calculations were computed as of April 19, 2010.
In the end, betting against a company is just another way to mitigate risk and lower a portfolio's correlation to the market. There is much more to the thought of betting against the rating agencies, but then again, if down the road they are alleged to have misled investors, such an investment would seem warranted, would it not?
I always welcome feedback and other thoughts to my posts. Thanks!
Full disclosure: Currently do not have any positions in the companies discussed.
