Analysts Late to the Alarm
Fallout From Subprime Crisis Casts Scrutiny on Ratings

By Tomoeh Murakami Tse
Washington Post Staff Writer
Thursday, December 13, 2007; D01

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.

"The credit markets team had it right the whole time, at least directionally," Wessel said. He added: "So I think it was easy to use that and say, 'There's something to this, let's apply it to the equity valuations.' "

Some Wall Street firms said they would increase coordination between equity and credit analysts in the future. "That is probably something in hindsight we would do more of going forward," said Greg Peters, who runs the fixed-income research group at Morgan Stanley. "In terms of what the fixed-income folks were thinking versus what translated with the equity market, I would say there was not enough coordination between those two markets generally."

Richard X. Bove, a stock analyst at Punk Ziegel, said the credit crisis was "impossible to miss." In an October 2006 report, he warned of "loan quality problems . . . that the banks have not prepared themselves to meet."

But he did not start downgrading the shares of banks and Wall Street brokerages to "sell" until July, when some had already begun to fall. (He recently upgraded some to "buy," saying their lower prices make them a good value.) Most of his peers maintained their neutral ratings on Wall Street firms, several of which have fallen nearly 40 percent this year.

Asked why he did not downgrade them sooner, Bove spoke of the pressure to always be right, the difficulty of going against the tide and the need to hang on to clients, which include mutual funds and other money managers.

"You live or die based upon your stock picks," he said. "If you think everything's terrible, but everybody else thinks things are great and they keep buying the stocks, and you put a sell too early, then people are just going to walk away from you . . . I've got to get paid also, and if I start putting sells on companies when the market momentum is forward, basically, people aren't going to pay me."

Negative views on a company, Bove added, could also jeopardize relations with management at the companies they cover, which are often necessary to provide a key service to clients: delivering executives for meetings.

"They're paying for travel agency service," said Bove, who said one potential client declined to pay for his services because he did not provide access to management. "They want company visits. That's what they're all about."

Bove added that the chief executive of one large financial services company, whom he declined to name, has shut him out after unfavorable reports. "You think he's going to travel with me to visit a client?" he said. "Absolutely not. He won't even talk to me."

The pay and stature of Wall Street analysts have greatly diminished since the tech bubble burst in 2001, when Eliot Spitzer, then New York's attorney general, subpoenaed firms that made handsome fees underwriting the initial public offerings of technology companies. Spitzer uncovered an e-mail in which Henry Blodget, a high-profile tech analyst at Merrill Lynch, disparaged the stock of a company he was publicly promoting. Subsequent reforms included a Securities and Exchange Commission rule that forbade firms from tying analysts' compensation to investment banking work.

Spitzer's successor, Andrew M. Cuomo, has also subpoenaed Wall Street firms as questions have arisen about their lining their pockets packaging and selling subprime mortgages that soon defaulted. People at the firms say analysts were not pressured to promote securities backed by those mortgages.

Kent Womack, professor of finance at the Tuck School of Business at Dartmouth, and a former vice president in the equities division at Goldman Sachs, noted that unlike the tech bubble days, analysts are no longer as motivated to skew their research because their pay is not tied to how many of these subprime securities their firms sell. But pressures remain, said Womack, who co-authored a study in 2000 showing analyst recommendations at investment banks that underwrote public offerings of stock were not as accurate as those of analysts at other firms.

"Equity analysts and debt analysts would recognize the important revenue and profit implications of helping out the investment banking department," Womack said. "The direct pressure is less, but it's still clear that if there's going to be a big investment deal, it's good for the whole firm and probably for the analyst to help out."

Wessel, of J.P. Morgan, said he works in a separate building from his colleagues who underwrite and sell subprime securities and doesn't even know them. Their business, he said, has no impact on his research. "In this business post-Spitzer, as a research analyst, the only thing you have is your reputation and your credibility," he said.

Staff researcher Richard Drezen contributed to this report.