Conflicts of interest in the analyst community are nothing new. Few probably thought the changes in the way buy, sell, and hold recommendations were made would have any lasting impact.
Despite reforms, financial institutions still do investment banking business with companies and their analysts still hand out ratings. Even if there is a corporate policy in place, like one that Merrill Lynch
When an analyst downgrades a stock, you gotta figure the company is hurting, right?
Well, if you look at the recent downgrade Credit Suisse
Considering the turmoil in the reinsurance business right now, it certainly looks like a plausible call. After a year of hefty premiums increases and no major storm damage, the ability to maintain such strength might be tough. Add in a new Florida insurance law that might take out Montpelier Re's business there and losses from a windstorm that were higher than expected, and Credit Suisse might have got it right.
Who's got short shorts?
Then again, maybe not. Could there be more to this than meets the eye?
Last June, as Montpelier Re sought to shore up its financial position in the wake of the devastating hurricanes the year before, it entered into a couple of equity "forward sale" agreements with Credit Suisse for about $180 million. That deal, and one that it had entered into the week before with W.L. Ross & Co., had given it access to additional sources of equity capital at a time when its underwriting business was favorable.
A forward sales agreement is a contract between two companies that gives one the right to buy or sell an asset from the other at some time in the future. No actual cash changes hands until the contract expires.
The deal with Credit Suisse let the investment banker short Montpelier Re's stock until the agreement concludes next month. The reinsurer's stock was trading at around $15 a share and essentially if it was still around $15 a share nine months later, Credit Suisse breaks even, not including some upfront premium payments Montpelier Re had to make of several million dollars. A bad hurricane season, some bad earnings, and if Montpelier Re's stock falls as a result, Credit Suisse is sitting on some sweet profits.
But things didn't happen like that. The weatherman was wrong and no major hurricanes materialized. Premiums were strong and earnings were even stronger. For the fourth quarter, net premiums rose more than six times to $53.2 million, earnings came in at $1.26 per share -- reversing year-ago losses -- and its book value jumped an amazing 33%, to $15.46 per share. Over the past eight months, Montpelier Re's stock has risen about 15% to around $18 per share.
The eye of the storm
That kind of performance is good news for investors, but it's not good if you're holding a short position due to be covered next month.
Under that forward sales agreement, Credit Suisse stands to lose around $20 million if Montpelier Re's stock price is $18 a share (but actually a little less if it goes a lot higher). Better for Credit Suisse if the stock declines from here.
Enter the downgrade. Talk about weaker pricing potential. Raise concerns over higher than expected losses from a windstorm. Chat up a complete loss of premiums in Florida's market. Suggest that firms with the most underwriting exposure will be hurt the most. Don't even mention anywhere that your firm has a big short position with the company you're downgrading.
Those are the kinds of conflicted analyses that got investment bankers in hot water to begin with. It makes you ask whether they should even be offering ratings on companies that they are so entangled with. It becomes hard to discern where investment banking analysis starts and market analysis ends. Such blurred lines in the past led to Citigroup
Foolish final thoughts
Unless someone comes across some emails again that contradict an analyst's stated opinion (I'm sure they've learned not to put their real thoughts in writing nowadays), it's doubtful any nexus between the downgrade and the short position could ever be proved. It's quite possible the Credit Suisse downgrade is predicated solely on the market forces outlined in its report.
The fact remains, though, that with investment banking so intertwined with a company's fortunes that these financiers ought to set the bar so high that the independence and veracity of their statements could never be called into question. Otherwise, such entanglements fall into the realm of things that make you go "hmmmm."