Ratings Agencies Move to Downgrading Each Other

In a move that smacks of throwing stones from its own glass house, one of the big three credit ratings agencies is threatening to downgrade the rating of one of its counterparts/competitors amid the seemingly imminent enactment of a federal financial reform package.

After weeks of criticism from lawmakers and experts directed at ratings agencies that had too many conflicts of interest in rating products from the financial industry, Standard & Poor's has placed fellow big three agency Moody's Corp. (Moody's Investment Services) on its negative CreditWatch list. In essence, S&P believes provisions within the massive financial reform legislation package, expected to pass the Senate and the president's desk within weeks, will increase litigation related costs for Moody's and force an alteration of its business practices. All of this will, in theory, lead to lower profit margins for Moody's, who perhaps were hit hardest from the Capitol Hill soapbox and were characterized as a "Aaa factory" for its easy-to-get high ratings, especially on packaged home mortgage loans, that failed to live up to their billing.

S&P explained its decision to put Moody's on the watch list, and in a very public manner:

"The agreed upon legislation contains a provision whereby investors may be able to sue rating agencies if they can show that the agency knowingly or recklessly failed to conduct a reasonable investigation of the factual elements relied upon by a credit rating agency's rating methodology, or obtain a reasonable verification of those factual elements from independent third-party sources. While we believe it is likely that the new pleading standard will lead to an increase in litigation-related costs at Moody's, whether the new pleading standard would potentially increase the likelihood of successful litigation against Moody's will be determined in the future by the courts. Moody's management has stated that it plans to adapt its business practices in an effort to partially offset any potential new litigation risks associated with the legislation. Nevertheless, we believe that Moody's may face higher operating costs, lower margins, and increases in litigation-related event risk...In addition, if the final legislation removes many or all references to nationally recognized statistical rating organizations (NRSROs) from federal regulations, it may reduce investor demand for ratings. While we believe the latter change is unlikely to meaningfully impair Moody's business position over the near term, we plan to consider its long-term impact. As per our criteria, greater business risk and lower profitability would be key factors in a potential downward revision of our evaluation of Moody's business profile or a potential rating downgrade. In addition, Moody's business will likely undergo noticeable changes due to new global regulations and the U.S. legislation's impact on industry risk, which are business risk considerations under our criteria."

S&P did note Moody's profitability has been strong and consistent in recent years and that it would resolve/update the CreditWatch status for Moody's in the "near term," likely soon after it analyzes the signed, final version of financial reform.

Brian Shappell, NACM staff writer

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