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.
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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.)

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Tickers in this Article: MCO, MHP, BRK.A, BRK.B, GLRE

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