Moody's Wells Notice Blues

By Eric Jackson
RealMoney Contributor
5/10/2010 5:00 PM EDT
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A couple of weeks ago, I offered up a negative short-term view of Moody's (MCO - commentary - Trade Now), saying it was too risky to hold the stock, given the Securities and Exchange Commission's suit against Goldman Sachs (GS - commentary - Trade Now). That move signaled regulators would likely pursue other high-profile symbolic targets, with Moody's near the top of the list.

Late on Friday, Moody's disclosed in its latest quarterly filing that it had received a Wells Notice from the SEC on March 18, saying Moody's Investors Service, the credit-ratings unit, may face SEC action over its June, 2007, application for renewal of its status as a nationally recognized statistical ratings company, or NRSRO, an official designation that is crucial to its business. According to Moody's, the SEC believes that the MIS "...description of its procedures and principles were rendered false and misleading..." in the application because the company had determined that one of its employees had violated its internal ratings committee policy.

Moody's said it disagreed with the Wells Notice and has submitted a response "explaining why its initial application was accurate and why it believes an enforcement action is unwarranted."

This news first broke on the Zerohedge blog, and has been widely reported since. It is big news, and in line with my previously stated concerns.

For those who don't know, the NRSRO status is enormously important for Moody's. The SEC determines which credit-ratings agencies can rate certain types of securities. Certain investors, think pension funds, can only purchase securities that have been rated a certain level by an NRSRO-accredited agency.

Until recently, only Moody's, Standard & Poor's, a unit of McGraw-Hill (MHP - commentary - Trade Now), and Fitch Ratings were official players. Then, a few years ago, the SEC widened the field, accrediting smaller players, such as DBRS, Egan-Jonesand others.

If the SEC stripped Moody's of its accreditation, it would shut the company out of a major part of its high-margin business, which would deal a huge blow to the stock, with likely spillover to other parts of its business. Earlier today, the stock plunged as much as 12.1% on the Wells Notice news, before recovering to close down 6.8%, at $21.77 a share in regular trading, on a day when the Dow Jones Industrial Average surged 3.9%.

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Why Take a Chance on Moody's?

By Eric Jackson
RealMoney Contributor
4/29/2010 1:15 PM EDT
Click here for more stories by Eric Jackson

Investors have been lulled into a sense of complacency about the prospects for Moody's (MCO -commentary - Trade Now) since its recovery off the March 2009 lows. Even though the stock has dropped since the SEC leveled charges against Goldman Sachs (GS - commentary - Trade Now) a couple of weeks ago, investors seem to have looked past all the market turmoil over the last two years and assumed that life is going to go back to normal for Moody's.

That is a false assumption. There are many reasons to avoid holding Moody's long at the moment.

The case in favor of owning Moody's is that the government is going to take a hands-off approach to regulating the ratings agencies that control anoligopoly (including S&P, which is owned byMcGraw-Hill (MHP - commentary - Trade Now), and Fitch). If this is the case, and if you have a recovering economy, then companies will need to issue debt as part of the lifeblood for growing their businesses, and they will need Moody's (and others) to sign off on that debt.

Moody's has historically printed money from this business. Gross margins for Moody's in 2007 were 74%. As a friend of mine who used to work for Moody's said to me, "The only people who get margins like that are gun-runners and drug cartels."

Up until the SEC's case against Goldman, I might have had to buy the status-quo argument -- as much as it sickened me. After all, how can you not say that Moody's and the other ratings agencies don't deserve to be further regulated after the Lehman market meltdown? Yes, there were many actors who deserved blame (including politicians and consumers, not just Wall Street banks). Yet the ratings agencies' remarkably blissful ignorance and failure to warn investors of possible risks to the housing market are shocking even now.

In the fall of 2008, post-Lehman, the agencies threw kerosene on a fire by classifying formerly AAA-rated super-senior tranches of housing-related debt as junk -- overnight. I'm not saying it wasn't junk, but how does AAA become junk in 12 hours? Clearly, the agencies should have flagged this as a concern much earlier and gradually marked the assets down. Instead, their helter-skelter move sent shockwaves of panic through the market, leading to a further decline in market prices.

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Note: Jackson had a short position in MCO at time of publication.

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