Bias on Risk
Rebonato said we need more regulation on our financial rating system, because they have some problem and caused 2008 financial crisis. They gave some companies AAA or other high grade that they suppose not to have (Rebonato). I agree this point. We need more concern about our risk management. And more regulation on those rating agencies, because they would have preference when they rating the debt.
In most cases, if we want to do some investment on bond, we will find a credit rating agency to help us figure out and rating how much risk we are facing to, such as Standard & Poor’s, and Moody’s. They give investors a reference when they invest debt or other things. Higher grade means lower risk. Could they ensure theirs rating is 100% correct? Let us see an example what happened in 2008 on a high grading company.
Bear Stearns Company founded in 1923 and headquarter located in New York. It was the 5th largest investment bank in America. In 2007, the 52-week high price is $159 per share. In Nov. 15th, 2007, Stand & Poor’s gave an A level for bear Stern’s long term debt rating and A-1 level of theirs short term debt (Bloomberg). It’s the 3rd highest level, which means has strong ability to meet their financial commitments and give back interest to the investor. Moody’s gave Bears Sterns an A2 level grading. I think those grading try to tell us bear Stearns is a healthy and good company. On Mar. 14th, Bear Stearns stock price dropped 45.9%, close at $30, the lowest point in 9 years. At the same day, Moody lowered Bear’s long term debt to Baa1, a medium grade (Market Watch). But only one trading day later on March 17th, 2008, JP Morgan Chase, which is an American multinational banking, purchased Bear Stearns. The price was $10 per share, a price far below its stock price before the financial crisis. People who lend money to Bern sterns have lost lots of money. What happened? Based on the income statement and balance sheet from bear Stearns, we could get some information.
Table 1 ($ million) (THE BEAR STEARNS COMPANIES INC.)
Nov.30,2007
Feb 29,2008
Asset
395,362
398,995
Liabilities
383,569
389,009
Equity
11,793
11,895
Debt-to-equity
32.53
32.69
Quick Ratio
OCFCL
-0.02
Net income
0.0052
0.0035
0.047
0.0096
0.0418
0.0061
The debt-to-equity ratio is 32.69 on Feb 29th, 2008, but it was average level among 5 biggest investment