Analysts Late to the Alarm
Thursday, December 13, 2007
NEW YORK -- Throughout 2006, T. Rowe Price analyst Susan Troll watched in horror as one risky mortgage deal after another hit the market. She became alarmed by a widening trend: mortgage lenders issuing home loans of poor quality that were then packaged and sold by Wall Street investment banks to investors worldwide.
Finally, she could stand it no longer. In e-mails and meetings with money managers, Troll urged T. Rowe Price to sell its portfolio of subprime mortgage securities.
"I just was amazed at how quickly these deals were getting done when you see constant deterioration in credit quality," she said. "I just said, 'It can't keep going up at this rate.' It just didn't make sense."
T. Rowe sold some of its subprime assets in December 2006 and cleared its books of them by early February -- well before the summer's credit crisis erased the market for these types of securities. Troll's warnings won kudos from James Kennedy, chief executive of the Baltimore firm, which has been posting impressive quarterly results.
Troll's actions were hardly the norm. Plenty of analysts did not sound the alarm on the subprime mess. The ensuing turmoil in the financial system has wiped out billions of dollars of shareholder equity at banks, investment firms, mortgage lenders and bond insurance companies. Five years after high-profile Wall Street analysts were accused of pocketing millions for promoting shoddy companies, analysts are once again in the spotlight for their conduct. Should analysts have seen the meltdown coming? Why didn't they? Did conflict of interest play a role?
There has been much finger-pointing, but no conclusions. One main issue, experts note, is that the complex alphabet soup of debt securities that have experienced explosive growth in recent years and are at the heart of the credit crunch are extremely hard to evaluate. That was the case, they say, even for some credit analysts whose job is to make calls on debt instruments -- not to mention for equity analysts who typically look at a company's earnings relative to stock price, cash flow and other factors.
Some Wall Street credit analysts were publishing reports advising clients to short, or bet against, certain subprime securities a year ago. Stock analysts, however, generally continued to affirm their largely neutral "hold" ratings on financial companies well into 2007. Some of those companies' shares have shed more than a third of their value this year.
"The fact of the matter is, most everybody in the industry, certainly analysts, never thought too deeply about these instruments," said Joseph Mason, associate professor of finance at Drexel University in Philadelphia. "The analysts didn't think about the instruments -- whether they be RMBS, CDOs or SIVs -- as anything different than the typical kind of investment like an equity." He was referring to residential mortgage backed securities, collateralized debt obligations and structured investment vehicles.
"In fact," he said, "they're very different from equities, and they're very different from even traditional debt instruments . . . It's a world that was really ill-suited for traditional equity analysts and even traditional debt analysts."
Troll is a credit, or fixed-income, analyst. She said she has never in her 10 years at T. Rowe spent so much time with equity analysts as in the past year, helping them understand the impact of the credit crisis on the balance sheets of companies they cover.
"The equity guys weren't really focused on it until it really hit their markets," said Troll, a buy-side analyst whose research is for the company's money managers and not available to people outside the firm. "I've spent a lot of time with equity guys just trying to explain the markets -- why they're so dislocated, why they're so bad, why this market is not coming back anytime soon in the form that it was and trying to help them value the securities that all these banks and insurance companies and everyone has on their books."
Andrew Wessel, a stock analyst at J.P. Morgan Chase who put a sell rating on the now-bankrupt New Century Financial in fall 2006, well before his peers, said he has benefited from experience on the mortgage desk at another firm as well as the work of his colleagues on the credit side who began advising clients to reduce exposure to certain subprime securities in mid-2006.