Only two weeks before the Justice Department informed rating agency Standard & Poor’s that it was about to be hit by a civil suit alleging fraud, analysts had been predicting that the share price of S&P’s parent company, McGraw-Hill (MHP), could rally to at least $62.
Instead of rising, McGraw-Hill’s share price has fallen by 20% so far this year, and further in the last few trading sessions, as seen in a stock chart, on news that the Justice Department and 17 other groups of regulators will seek damages for what they allege to be fraud on the part of S&P. The specific claims hinge on the rating agency’s decision to slap investment-grade ratings on what turned out to be risky mortgage-backed securities back in the heyday of the subprime lending market, before the 2008 financial crisis.
McGraw-Hill isn’t the only company at risk. Moody’s Corp. (MCO), owner of the other big rating agency of the same name, has also seen its stock price tumble. Whether it is political vindictiveness (S&P, notably, downgraded the U.S. government’s own debt rating in 2011) or the fact that the Justice Department believes it has a stronger case and a bigger smoking gun in the case of S&P, it’s unlikely that Moody’s will escape scot-free. After all, former Moody’s employees testified to the Federal Crisis Inquiry Commission that they came under constant pressure to do whatever it took to keep their market share high and win deals and deal fees from the banks putting together those packages of mortgage-backed securities that needed rating.
The Justice Department’s case is a bit of a risky one, at least in part because it does look political in nature. It’s also going to be hard to get a jury to understand the complexities of structured finance, or to convince them S&P’s rating decisions – however flawed they look in hindsight – weren’t made in good faith at the time. Sure, one S&P employee said, in an e-mail contained in the suit, that a deal “could be structured by cows and we would rate it." What that employee didn’t say was that he would give it a triple A rating. The plaintiffs will need to demonstrate something more direct and deliberate than Ohio state pension plans were able to do: in December, a federal appeals court rejected a suit by these investors based on roughly similar grounds, upholding a lower court ruling that S&P’s ratings were ‘opinions’ that are protected by the First Amendment because the S&P analysts believed them to be accurate.
So, does the fact that the regulators face a tough job prosecuting this case mean that it’s time to treat McGraw-Hill or – better yet – Moody’s as stocks with great long-term prospects and upside potential? Not at all.
While the rate of growth in McGraw-Hill’s revenue has been steady, its growth in profitability has been less impressive. The company last year unveiled plans to overhaul its business and ultimately to split the company in two, with one half focusing on its publishing operations and the other its more lucrative credit rating and financial data divisions. Ahead of the lawsuit, the company had taken steps in that direction, such as selling a chain of radio stations last year for $212 million. But the move is far from complete.
Moody’s seems to have been in a better position. The company reported a big jump in its third-quarter profits (its report for the fourth quarter is due out on Friday), and boosted its forecast for the full year thanks to a boom in corporate debt issuance. Still, some analysts had warned that the stock’s price was overvalued, especially given the fact that in a slow-growth economy, there is a finite amount of corporate debt to be issued or refinanced. At some point growth will become more robust – but at that stage, interest rates also are likely to climb. The PE ratio of both stocks had climbed to the high teens before the Justice Department action.
In the meantime, as the chart above portrays, the growth in Moody’s expenses has outstripped its growth in revenue. In part, that is due to higher headcount, but both rating agencies have commented on the higher costs associated with rising levels of regulation.
And regardless of the ultimate fate of the Justice Department’s lawsuit, it could influence the shape of future such regulation. Back in mid-December, rating agencies believed they had scored a coup when the SEC staff suggested convening a roundtable to discuss the best way to deal with potential conflicts of interest in the credit rating business rather than recommending a more draconian and immediate action. (The expectation had been that the SEC would propose creating an independent board that would oversee which agency is given what structured products to rate, or something similar.) For a roundtable to take place against the backdrop of fresh revelations and allegations surrounding rating agency conduct in the run-up to the financial crisis could prove bad news, and very costly to both firms – if not as pricey as a $1 billion settlement (rumored to have been the price required by the Justice Department to not file its civil suit) would have been to McGraw-Hill.
There appears to be altogether too much headline risk associated with these stocks for the time being for them to be worth acquiring at anything but a discount, and even then, given what is likely to be more intense scrutiny on the part of regulators of their business models, the business risk appears likely to increase. Ironically, you may be better off investing in one of the banks whose reckless lending and poor risk management were more directly responsible for the crisis.
Suzanne McGee, a contributing editor at YCharts, spent nearly 14 years as a reporter at the Wall Street Journal, in Toronto, New York and London. She is also a columnist for The Fiscal Times, and author of "Chasing Goldman Sachs", named one of the best non-fiction books of 2010 by the Washington Post. She can be reached at email@example.com.
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