Why Take a Chance on Moody's?

By Eric Jackson
RealMoney Contributor
4/29/2010 1:15 PM EDT
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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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