S&P Story

You probably think I’m going to write the umpteenth story about the recent downgrade of long-term US Treasuries.  If that’s what you want, I’m sorry to disappoint.

Instead, I’m going to tell you about the danger of being blinded by your own cleverness, especially when your smartest people fall in love with a model.

Back in 2002, I had a large holding of Corning stock, or glass works, as I had called it since first buying stock in it back in the 1970’s.  In 2002, the yammering crowd called it an Internet stock, or a fiber optic company.

I knew it was much more than that.

When I first bought GLW stock in the 70’s, it was because I saw the intricate machined ceramics they gave away at the International Solid State Circuits Conference.  They were doing things with glass that no one else could.  In fact, that was how they had survived since before the Civil War.  When Thomas Edison needed glass to make his first light bulbs, he went to Corning.

The thing about glass is that it’s half industrial know-how, and half art.  It has to be “cooked” and then cooled just so, or it won’t perform.  It’s as much a recipe as an industrial formula, and it can be at least as temperamental as a soufflé.

Every window on every NASA space vehicle came from Corning, as did the gigantic glass “blank” that went into the Hubble space telescope and plenty of earthbound observatories.  And all of us from America’s post-war generations remember their Corelle, Corningware and Pyrex brands (divested in 1998).

When I loaded the boat in 2002, it was after the stock collapsed from a price of several hundred dollars (riding the internet bubble) to just a few bucks. As I recall, I began buying the stock around seven bucks a share in late 2001 or early 2002.

I knew they could make the fiber (better than anyone else), but they also could make exhaust filters for trucks that brought old trucks into compliance with new pollution standards.  They also made the really flat glass that people were putting on flat panel displays and TVs.  They had over 4,000 patents.  Even the Chinese had just sold them their biggest glass fiber plant because they couldn’t quite cook it well enough.  To get it right required the touch of the masters.

Unfortunately for Corning, they had succumbed to the lure of the bubble in the 90s, and expanded, bringing in a CEO with international experience, global vision, and grand spending plans.  By the time I bought in, a member of the founding Houghton family had come back to save the family business.

Still, the dire financial straights that Corning was in because they extrapolated the fiber optic growth curve forced them to take horrible terms from Wall Street near the bottom of the 2002 bear market.  They priced a mandatory convertible preferred bond on June 30 that year, but it had the features of what was called “death spiral” financing, announced ahead of time to prospective buyers.

The hedge funds who were buying the new bonds were able to sell stock short ahead of the bond pricing, knowing full well that the conversion price would be the stock price the day the bond deal got announced.  It went all the way down to a buck a share.  I got killed in my (for me) large holding, since it was an instant large margin call.

Still, they raised enough capital to survive and retire all the debt that came due over the next five years.

The thing that was insult added to injury was the rating action by S&P a day or two after the offering.  They lowered Corning’s bond rating.  It made no sense.  Even though they had been royally screwed by the front-running of the deal (more than 100 million shares traded the day before the converts priced), Corning had succeeded in eliminating debt with a fixed maturity as a risk, and replaced it with equity.  The financial condition of the company had absolutely improved, from a credit standpoint.

As it turned out, some months later I was in a position to be a client for S&P that was going to pay a fee of several hundred thousand dollars for a new bond rating.  I decided I would ask the ratings people I dealt with to put me in touch with the people who had made the downgrade decision on Corning.

When I asked them how they came to the conclusion that Corning deserved a downgrade after pricing that convertible, I was told that S&P had developed a new model for corporates that took stock prices into account.  The theory was that the stock market may know something the bond market hasn’t recognized, so a large rapid decline in a stock’s price was an indication that there was serious financial trouble.

Standard and Poors was so enamored of their research that they forgot to look at the improvement in the balance sheet, and especially forgot to realize that the stock price action was the arbitrageurs working their evil magic, not some secret signal from the all-knowing market that unseen disaster loomed.

If anything, they should have upgraded Corning’s credit, not downgraded it.


PS Just to be clear, I am not one of those who thinks S&P should have predicted the subprime mortgage meltdown.  They probably should have recognized the fraud that Wall Street securitizers were passing on from unscrupulous mortgage brokers, that’s true. 

What they definitely should not have done is what so many of their critics insist on — issued ratings based on what might happen that had never happened before.

I’m sorry, but I don’t want an analyst’s personal opinion to overrule what the historic data shows.  They acted as NRSRO’s (Nationally Recognized Statistical Rating Organizations), and they had no business throwing out the four decades of data on millions of mortgages to boldly go where the housing market had never gone before.

That is best left to speculators, not Rating Agencies.



2 Responses to S&P Story

  1. Mike Friedman says:

    Howard — I love you and your blog, and I know that you are easily two times as smart as I am. And that you know the financial industry, and I do not.
    But you are just wrong about S+P not recognizing a bubble. The Holland Tulip Bubble looked like high quality investments, the South Sea Land Bubble similarly. And the High Tech bubble. The Mortgage Derivatives debacle was not the first of its kind. I do not believe that S+P were not permitted to see outside the bubble to see that it was in fact not an expanding universe, but a bubble near bursting. Around 2002 I had information indicating that the mortgage derivative market was a scam, and I do not believe that I alone had that insight. The company that had responsibility to rate the bonds certainly knew everything I did, and ignored it all. S+P made a lot of money selling (lies) good ratings, and the hypothetical honest guy who blew the whistle would have been fired or killed. Maybe there is a pile of bones in a closet at S+P, of honest people who were going to blow the whistle.

  2. hhill51 says:

    Oh, man, am I ever angry at myself!
    I had done a detailed, lengthy response to this, and it got so long that I decided to make it a brand new post. In the process of going to post it as a new post, I lost the whole thing.
    I’m sure I’ll be able to recreate most of the points, but sometimes it never comes back with the same crisp and interesting turn of phrase.
    Why is saving my work on a computer one of those lessons I’m doomed to keep learning for the rest of my life?

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