The US Government Sues Standard & Poor's

The US government recently announced plans to sue Standard and Poor’s for the company's role in the recent financial crisis, specifically the way it assigned investment grade ratings to products that turned out to be junk - or worse. Reports suggest that McGraw-Hill, Standard and Poor's parent company, rejected a deal that would have involved paying $1 billion, along with an admission of wrongdoing. Refusing the deal may have been a mistake: after all, $1 billion is about what the company earns in a single year, and officials and experts alike have citied a far higher figure if the government prevails in a court case. The market's early verdict seems to be that the government will prevail, as the prospect of a trial has lopped about $4 billion from McGraw-Hill's market value. Moody's, the other member of what Warren Buffett (Berkshire Hathaway is the single largest shareholder of Moody's) calls a "duopoly" in the ratings industry, has suffered a similar percentage decline in its stock, on the fears that it behaved in the same way as Standard and Poor's, and thus faces a similar fate.

This may yet become an excellent buying opportunity for investors. After all, Buffett was right that the two firms enjoy an entrenched duopoly. Regulatory changes in the post-2008 years have not increased competition in practice, and may not have even encouraged it in theory. Far higher costs in the areas of compliance have the effect of insulating the "Big Two" from smaller upstart competitors. And while both companies clearly assigned unjustifiably high ratings to many risky securities, it's not clear that increased competition would be a remedy. In fact, it could make it worse: more competition could prompt a race to the bottom, where agencies would be tempted - or almost forced - to gain market share by offering generous ratings.

At present, there are too many uncertainties, in the writer's opinion, to invest with confidence. For one, even the sharp decline in the companies' share prices are not fully accounting for the costs of an extended trial that could end in costly defeat. Though both companies have the financial strength to withstand penalties of $1-3 billion; the real question is what happens to their competitive position. If a duopoly - or an oligopoly with just 4 or 5 big players, where Standard and Poor's and Moody's lead the pack - remains intact, the future earnings power of both businesses will remain strong. The fact that the US government was willing to strike a deal suggests little interest in dismantling the status quo in the ratings industry. In fact, both companies are so deeply entrenched in the financial system that it may not even be possible to make radical changes. No government, corporation or any other large entity can issue debt without a rating, however ill-considered that rating may be. As the case proceeds, investors will be watching with great interest, for there may be an opportunity to buy one or both of the ratings powerhouses at a bargain-bin price.

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