Friday, May 21, 2010

The Quality Issue -- Again

In my post of May 14 entitled “The Wheat From the Chaff” I said I’d write next about the recent comments from Bill Gross of PIMCO and the new work of Edward Altman of NYU on the issue of quality/credit ratings.

I got sidetracked a bit but now I want to return to that topic.

I’ve argued previously that, if TRE is to realize its growth aspirations, it will eventually have to provide SOME means for Buyers to more conveniently differentiate Seller financial strength and transaction quality.

The Exchange doesn’t have to actually DO that itself; it can outsource the function. Or it can co-operate with a 3rd party service provider who might see an opportunity to create a new business line or to leverage an existing one.

But the current system, which requires that each Buyer analyze the financial data made available by each Seller, and keep checking for and analyzing updates, is not going to work when there are actually hundreds or even thousands of Sellers.

In his May “Investment Outlook” piece, Bill Gross essentially dismisses the three big bond-rating agencies: Moody’s, S&P and Fitch, as purveyors of Kool-Aid to an “unsuspecting (and ignorant) investment public”. The solution for PIMCO is to have its own large credit staff that can “bypass, anticipate and front-run all three, benefiting from their timidity and lack of common sense”.

Now, when someone as smart as Gross can have so little respect for the analysis of a Moody’s or an S&P, even given the level of their experience and the quality of the information they have to work with, you have to ask whose analysis CAN be trusted.

I’ve written before about the condition of TRE Seller financial statements: not only about their quality but also their timeliness. The information that S&P has to work with in analyzing a bond issuer is, I suspect, much more likely to be accurate and timely than the financials provided by the majority of TRE Sellers.

Most TRE Buyers will not be able to follow the PIMCO lead and have large in-house credit analysis departments. They’re going to have to make do with less. They’re also not going to have the same quality of information. But that doesn’t mean that NOTHING can or should be done.

Edward Altman, developer of the well-known “Z-Score” Analysis has shown that near-term insolvency of businesses can be predicted with a high degree of accuracy based on metrics that are readily calculated from financial statements.

Altman and his associates have just published (March 2010) an updated version of their analytical tools, which appear to further improve their predictive power.

It’s true that these newer Altman metrics are more applicable to larger businesses than are currently found on the Exchange, but the notion that there are relatively easily-applied tests with strong predictive powers is still important.

There are three basic elements of risk assessment that are important to a TRE auction:

a) As to the Seller: the ability to make good on a defaulted invoice and the likelihood of its solvency in the near term,

b) As to the Account Debtor: the ability to pay its obligations and the likelihood of its solvency in the near term, and

c) As to the receivable purchased: the level of certainty that the obligation represents actual sums owing for work done or services properly provided under binding agreement between the parties. And the extent to which there are other claims that might be superior to that of the Buyer.

These are all issues that can be addressed, admittedly with varying levels of confidence. But SOME level of confidence, based on a reasonable attempt at analysis, is better than either guesswork, hope or blind faith.

I can understand that TRE might not want to present any analysis of its own, fearing liability in the event of loss. But that doesn’t mean it could not contract with a third-party provider to look at these three basic elements of risk analysis and assign a quality rating that reflects the three areas of fundamental risk listed above.

Such an analysis would be less robust than most in the financial world because of the quality of the data available, but it would have to add value when compared to the currently available information.

If the Exchange can convince its backers that there is a large enough potential volume of business to warrant their equity investments, I suspect it is persuasive enough to convince a 3rd-party analytical group to take on this quality-rating task!

Such an effort would benefit all who hope for Exchange success.

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