Years ago, the rating agencies were just the types of business that value investors loved to own. After all, these are businesses with dominant franchises, recurring revenue streams and a monopolistic operating environment.
IN PICTURES: Eight Ways To Survive A Market Downturn

The Big (and Only) Three
In fact, virtually all ratable credit instruments are rated by either Moody's (NYSE:MCO), Standard and Poor's, which is part of McGraw Hill (NYSE:MHP), and Fitch Ratings, which is majority-owned by the French company Fimalac.

Considering that no bond can be priced and sold unless it's rated by a major rating agency, it's not surprising that Warren Buffett's Berkshire Hathaway (NYSE: BRK-A)(NYSE:BRK-B) invested into Moody's many years ago. Buffett continues to hold Moody's, but has recently been selling off Berkshire's stake. Investors should remember that Buffett bought into Moody's many years ago and has a cost basis that still leaves him with a profitable holding. At the same time, over the years the rating agencies have relied more and more on the ratings business, versus the other lines of business like publishing, to fuel earnings growth. (For related reading, check out What Is A Corporate Credit Rating?)

A New World
In a normal world, the rating agencies would still be considered incredible cash-generating machines. Unfortunately, many experts argue that one of the root causes of the financial credit catastrophe last year was a result of egregious rating standards on behalf of the rating agencies. And it seems like the rating business is due for some heavy doses of regulation.

To be fair, rating agencies argue that they are not experts, but merely work to provide a service, and their ratings are mere opinions which should be protected by the right to free speech. (For more, check out The Debt Ratings Debate.)

Whether or not the above holds true, the SEC is taking a very hard look at imposing extremely stiff regulations and higher standards of accountability for the rating agencies. Evidence is even starting to appear that despite the fact that the rating agencies were expressing opinions, many employees were more than aware that they were giving investment grade ratings to some awful stuff.

Shorting the Ratings Agencies
In fact, such behavior has hedge fund manager David Einhorn short both Moody's and McGraw Hill. Einhorn runs Greenlight Capital and is Chairman of Greenlight Capital Reinsurance (Nasdaq: GLRE). Last year, Einhorn was vocal about Lehman Brothers and why it was insolvent months before the bank actually went under. Needless to say, his going short Lehman paid off tremendously.

Bottom Line
Regardless of what happens, it is a near certainty that the rating agencies will ultimately be under some sort of very onerous regulatory standards; the consequences of the credit crisis were too severe. So, despite any temptation to own a piece of these dominant franchises, investors would be well advised to ignore them for the time being. (For further reading, see A Brief History Of Credit Agencies.)

Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!

Related Articles
  1. Mutual Funds & ETFs

    4 Mutual Funds Warren Buffet Would Buy

    Learn about four mutual funds Warren Buffett would invest and recommend to his trustee, and discover detailed analysis of these mutual funds.
  2. Stock Analysis

    Markets Are Tanking: Time to Buy Like Buffett

    Learn about three value stocks Warren Buffett holds in his portfolio. See how Buffett uses market declines to find good deals on stocks.
  3. Stock Analysis

    3 Stocks that Are Top Bets for Retirement

    These three stocks are resilient, fundamentally sound and also pay generous dividends.
  4. Investing News

    Are Stocks Cheap Now? Nope. And Here's Why

    Are stocks cheap right now? Be wary of those who are telling you what you want to hear. Here's why.
  5. Investing News

    4 Value Stocks Worth Your Immediate Attention

    Here are four stocks that offer good value and will likely outperform the majority of stocks throughout the broader market over the next several years.
  6. Investing News

    These 3 High-Quality Stocks Are Dividend Royalty

    Here are three resilient, dividend-paying companies that may mitigate some worry in an uncertain investing environment.
  7. Stock Analysis

    An Auto Stock Alternative to Ford and GM

    If you're not sure where Ford and General Motors are going, you might want to look at this auto investment option instead.
  8. Mutual Funds & ETFs

    The 4 Best Buy-and-Hold ETFs

    Explore detailed analyses of the top buy-and-hold exchange traded funds, and learn about their characteristics, statistics and suitability.
  9. Investing

    Procter & Gamble Restructures, Sheds 100 Brands

    All businesses face adversity, and Procter & Gamble is no exception. We take a look at recent developments affecting this global giant.
  10. Mutual Funds & ETFs

    What Exactly Are Arbitrage Mutual Funds?

    Learn about arbitrage funds and how this type of investment generates profits by taking advantage of price differentials between the cash and futures markets.
  1. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  2. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  3. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  4. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  5. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
  6. What is the difference between issued share capital and subscribed share capital?

    The difference between subscribed share capital and issued share capital is the former relates to the amount of stock for ... Read Full Answer >>

You May Also Like

Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!