Rating Agencies: Apparently Failure Is An Option (MCO, MHP)

By Eugene Bukoveczky | February 07, 2008 AAA

Despite his legendary investment savvy, there is speculation Warren Buffett might have got it wrong when he took an 18.6% stake in long-established bond rating agency Moody's (NYSE:MCO). Over the past year, Buffett's investment in Moody's is estimated to have dropped by about $1.77 billion as Moody's shares have lost about half their value.

So, why have the shares tumbled? Like so much else in the financial services sector these days, we have to blame this, too, on the subprime meltdown.

Bad Advice Stings Bond Investors
In the world of bond investment, rating agencies like Moody's and rival Standard & Poor's, a unit of publishing giant McGraw-Hill (NYSE:MHP) wield enormous power. Investors rely on them almost exclusively for opinions regarding the creditworthiness, or risk of default, they assign to bonds and money market instruments issued by a wide variety of corporate and financial borrowers.

Issuers and investors were generally happy with the way things worked - that is, until the subprime disaster hit. It now looks that the rating agencies were too quick to assign their best 'triple-A' rating to mortgage-backed and asset-backed securities, including collateralized debt obligations, and too slow to downgrade them when it became obvious that many of these instruments are now virtual write-offs. Some have even suggested their actions, or lack thereof, have materially contributed to the severity of the current turmoil in capital markets.

Criticism Prompts Ratings Scheme Change
In an effort to respond to the growing chorus of criticism about how they do business, which now includes an investigation by the Securities and Exchange Commission (SEC) as to whether rating agency analysts were unduly influenced by the companies they cover, Moody's and Standard & Poor's recently announced changes in their internal practices and new ratings rankings based on a numerical as opposed to the previous alphabetically based system. However, critics remains skeptical that the changes are anything more than a public relations move and cite the fact that the real issue, the fact that the bond issuers pay for the ratings opinion, continues to pose a conflict of interest problem.

A glaring example of this, at least in the opinion of David Einhorn, a widely followed hedge-fund manager at Greenlight Capital, is the way Moody's and Standard Poor's continue to assign top ratings to debt instruments issued by struggling bond insurer MBIA (NYSE:MBI). A recent $1 billion notes issue by MBIA garnered a near top 'Aa2' and 'AA' from Moody's and S&P respectively, despite the company's problems. (For everything you need to know about these ratings, check out What Is A Corporate Credit Rating?)

The Bottom Line
For long-term strategic investors like Buffett, events like this are just short-term noise. His investment thesis appears to be grounded in the basic truth that bond issuers and investors will always have to rely on a third party opinion on the creditworthiness of the debt instruments involved. The system will always need a standard benchmark. The recent campaigns to restore credibility are facing a healthy dose of skepticism, but in time, all this will pass and things should return to normal. Is Buffett worried? Not on your life.

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