A Temporary Setback for Credit Raters

Credit-rating agencies are losing the blame game. As Wall Street, regulators and investors try to get their stories straight about what has caused the current bout of economic unease and market turmoil, one thing they can agree on is that rating agencies are partly at fault.

The summertime blues were back on August 28, with the Dow Jones industrial average plunging 280 points, or 2.1%, and Standard & Poor's 500-stock index sinking 2.3%. Shares of Moody's (symbol MCO), the only pure-play credit rater, fell 2.9%, to $44.83, and are now down 37% so far this year.

McGraw-Hill (MHP), which owns S&P, the other major credit rater, dropped 4.0%, to $49.83, and is now down 26% so far in 2007.

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Rating agencies make easy targets. In addition to assessing the credit-worthiness of bond issues, raters advise investment banks and other underwriters on how to create securities backed by subprime mortgages and credit derivatives.

For years, many of these mortgage-backed securities were given triple-A ratings on par with grades for bonds issued by well-financed companies. But these securities have lost value as a growing number of borrowers defaulted on the underlying mortgages.

That caused some hedge funds to crater and recently prompted central banks to intervene to keep the credit markets from seizing. Meanwhile, rating firms downgraded scores of these securities and changed the methodology they use to evaluate mortgages.

The credit squeeze has dried up demand for mortgage-backed securities. That doesn't bode well for ratings firms. More than 40% of Moody's' and S&P's revenues over the past year came from rating these securities and other so-called structured-finance products. Rating fees for those complex products are usually twice as much as fees for evaluating bonds issued by corporations because of the extra work involved.

The credit-rating industry is essentially a duopoly. Moody's, S&P and Fitch, which is a unit of Paris-based financial services group Fimalac, are the largest players. But Moody's and S&P each hold about 40% of the credit-rating market, with Fitch and the small fries dividing up the remaining 20%.

Last year, Congress passed a law, designed to increase industry competition, that makes it easier for other firms to gain certification from the Securities and Exchange Commission as "credible and reliable" raters. Currently, the SEC recognizes six companies.

Moody's and S&P face a slew of complaints. The mortgage mess has attracted the attention of lawmakers and regulators. Securities regulators from the European Union are reviewing the management and practices at the rating agencies. Members of Congress have demanded more industry oversight and called for hearings.

In addition to more government scrutiny, ratings firms are likely to be slapped with lawsuits by investors who lost money in mortgage-backed securities and argue that the raters didn't provide adequate warnings.

Although the picture looks bleak, there are reasons to believe that the raters' problems are temporary. Despite the regulatory maneuvers, "there's nothing that would meaningfully change the companies' business models or leadership positions," says Neil Godsey, an analyst with investment bank Friedman, Billings, Ramey & Co.

Investor lawsuits have little impact because courts have found that opinions of rating agencies -- even if they are dead wrong -- are protected by the First Amendment. The clog in the debt pipeline will ding future revenues and earnings from ratings, but the business won't disappear, as debt issuers will continue to clamor for ratings from Moody's and S&P.

Most debt issued requires two independent ratings. Issuers and investors want to use as few rating agencies as possible, so they will stick with the market leaders no matter how many new competitors the SEC blesses. And as the global market for debt keeps expanding and Wall Street keeps churning out new products, demand for ratings services will grow.

Shares of Moody's and McGraw-Hill dwell at their lowest price-earnings ratios over the past five years. Moody's trades at 16 times the $2.89 per share that analysts expect the company to earn in 2008.

McGraw Hill sells for 14 times the $3.50 per share that analysts expect it to earn next year. (Credit rating makes up a little more than half of McGraw-Hill's business. The company also publishes educational and financial information and magazines, such as BusinessWeek.)

Godsey gives both stocks "Outperform" ratings. He has an 18-month target price of $85 for Moody's and $83 for McGraw-Hill. But while markets roil, Godsey expects these stocks to suffer.