To add to the troubles of Standard & Poor's (S&P),
fellow ratings firm
) have cut the debt rating of its parent company
The McGraw-Hill Companies, Inc.
) by two levels -- to Baa2 from A3 -- on Valentine's Day, and has
said it may reduce it again.
In November 2012, Mc-Graw Hill sold its education arm to
Apollo Global Management, LLC
) for $2.5 billion. Subsequently, it has not included results
from its education unit in its financial results and reported
losses of $216 million in the fourth quarter. The new rating from
Moody's takes into account the sale of McGraw-Hill's education
arm as well as the civil lawsuit filed against the company by the
Department of Justice.
The US Department of Justice has recently filed a $5 billion
civil fraud case against S&P. Its parent McGraw-Hill has lost
more than 20% since the beginning of the month, wiping out $3.75
billion of market value. Yields on $800 million worth of
outstanding bonds have risen by as much as 0.9% since the lawsuit
was filed on February 5. Clearly, Standard and Poor's fortunes
have been grievously affected by this development.
The first ever against a credit rating agency, the major
accusation of the lawsuit is that the agency provided inflated
ratings on $5 billion worth of mortgage related securities and
misled investors. The incentive in this case was hundreds of
millions of dollars in ratings fees which were paid by the
issuers of these securities. Precisely, S&P assigned these
ratings in pursuit of lucrative ratings fees and higher market
However, according to an analyst at BTIG, LLC, Moody's also faces
the risk of similar litigation in the near future. This may also
have provided S&P ideas for a "similar announcement" shortly,
the analyst opined. Moody's shares had taken a hit right
after it was leant that rival S&P had been served a civil
lawsuit. Share prices had declined even though Moody's posted a
66% jump in net profit in the last quarter of 2012.
Many commentators have cited the faulty model of the ratings
industry as the source of all its ills. The issuers of debt
instruments select ratings companies to rate their securities and
pay them ratings fees. These fees had touched $150,000 for rating
a residential mortgage-backed security and $750,000 for a
synthetic collateralized debt obligation.
Even the Justice Department's lawsuit points out that this was
the primary reason for the ratings firms' conflict of interest.
Ratings are crucial for the buyers of such instruments, but fees
are received by ratings firms from issuers, an inherent
The Dodd-Frank legislation seeks to replace this system wherein
the Securities and Exchange Commission (SEC) would set up an
independent board which would select which ratings agencies would
rate a particular class of asset-backed securities. Following
this, the system would be expanded to ratings of all debt
Further, the SEC could create different certifications for
rating different kinds of debt and prevent ratings firms from
issuing ratings on more than one category. This would encourage
competition and the entrance of new players.
MOODYS CORP (MCO): Free Stock Analysis Report
MCGRAW-HILL COS (MHP): Free Stock Analysis
PIPER JAFFRAY (PJC): Free Stock Analysis
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An analyst at
Piper Jaffray Companies
) has taken a contrarian view of things, citing "manageable
litigation risks." He further added even after four years of an
exhaustive search, "the 'smoking gun' that would prove fraud has
failed to materialize." The analyst then went on to recommend
that investors purchase stock in both McGraw-Hill and Moody's,
saying there prices may increase appreciably in the future.
What cannot be ignored is that S&P was analyzing subprime
mortgage data that was also accessible by the rest of the market.
In fact, the securities which the Justice Department has held up
as an example received near identical ratings from other ratings
firms. S&P also cut ratings of several mortgage-backed
securities in 2007. It also issued warnings about the housing
Thus, it could also be argued that the entire financial risk
management system could not correctly evaluate the decline that
was to come. This is what slowed down S&P from acting, though
it cut ratings earlier than its industry rivals. Unless far
reaching systemic changes are rung in, this could only be a
temporary hiccup for ratings firms. However, there long term
future seems undisturbed.