Last week, dire news regarding a government probe of Standard & Poor’s parent company McGraw-Hill (MHP: Charts, News, Offers) led to speculation that the other two major credit agencies, Moody’s (MCO: Charts, News, Offers) and Fitch, were next on the government’s hit list. Moody’s has now been thrust into the spotlight as a former Moody’s senior analyst, William Harrington, has stepped forward to accuse the company of corruption. Harrington was employed by Moody’s for 11 years and held the post of Senior Vice President of the derivative products group, the segment responsible for some of the disastrous ratings the company issued prior to the housing bubble which caused the global financial crises of 2008-2009.
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Harrington has issued a 78-page reply to the SEC’s proposed rules of regulating credit rating agency reform, citing conflicts of interests, poor management and corruption at the highest levels of Moody’s. The underlying theme of his complaints is familiar to industry watchers – the fact that Moody’s is paid by its clients for its coveted ratings, causing Moody’s to become obligated to pass out favorable ratings to its most valued customers in order to maintain a profitable business model. Harrington has claimed that this broken business model causes Moody’s employees to hand out favorable ratings like candy in order to retain customers and stay competitive with other credit ratings agencies. Harrington also states that Moody’s analysts who held a dissenting opinion regarding a customer’s favorable credit rating were perceived as “impeding deals” and harmful for the company’s business, and in many cases were “transferred, disciplined, harassed or fired.” In other words, he claims that Moody’s runs a business of simply peddling favorable credit ratings with little concern for the damage done to the economy and individual investors.
Harrington has described Moody’s recent attempts to reform this culture as a “pretty-looking PR campaign” which ultimately changes nothing. Analysts at Moody’s do not have a final say in the final rating of a company. Instead, rating committees privately conclude on an acceptable rating, then vote with Moody’s executive management on client requests for higher ratings. According to Harrington, Moody’s product managers, the same people responsible for retaining clients and keeping them happy, are allowed to vote in these rating decisions, which causes an impossible conflict of interest that renders the company’s ratings useless and dangerous. In the past, two senior executives were brought to a congressional hearing over the company’s poor ratings prior to the housing bubble. Harrington alleges that one “lied under oath” while the other skipped hearings altogether. Faced with such damaging accusations from a high level executive, the media expected Moody’s to fire back quickly with the typical “disgruntled employee” defense. However, Moody’s has remained silent on the situation, and to many investors, its silence is damning.
Bad PR aside, the company actually posted strong earnings this last quarter, reporting a profit of 82 cents per share, or $189 million, on revenue of $605 million. This was a 56% increase in earnings on a 27% rise in revenue. This soundly beat the analysts’ average expectations of 57 cents per share. In addition, Moody’s raised its full-year profit guidance from $2.22-$2.32 to $2.38-$2.48. However, like most other company’s reporting earnings these days, the Moody’s warned of macroeconomic uncertainties in the second half of 2011 weighing down its bottom line. Moody’s debt issuance business is likely to decline due to the plunging value of corporate bonds, which has decreased investment grade bonds’ value by 55% and dropped junk bonds’ value by 67%. The credit rating agencies, which have been wrestling with an out-of-control Europe, have also been more alert these days than prior to the housing bubble. They have acted quickly to cut sovereign debt ratings in Ireland and Portugal. Moody’s concentrated on building up its free cash reserves – up to $935 million from $720 million three months ago. Although the company still has $1.1 billion in buybacks authorized by the board, the company is concentrating on making sure that it is well-capitalized enough to face any unexpected economic and legal hurdles that may be caused by a meltdown of the Eurozone. Moody’s CFO Linda Huber also told analysts that 70% of its cash reserves are deposited overseas to offset any troubles at home with the U.S. economy and the dollar.
Compared to its over-diversified industry peer McGraw-Hill, Moody’s is a streamlined business, focusing only on two business segments – Moody’s Investors Service and Moody’s Analytics, the former focuses on credit ratings and the latter offers risk-management services. The company’s respective net profit and operating margins of 31.5% and 44.6% are both an improvement over the previous year, and are the highest in its industry. With a cheap trailing P/E of 10.2, Moody’s should be tempting to value investors. Unfortunately, recent market volatility and the threat of a government probe amid scathing allegations should keep investors at bay.
Other News About MCO
Does DOJ probe mean the government is finally turning up heat on the rating agencies?
Why has it taken so long for the government to realize that the rating agencies are overpowered?
Ratings agencies suffer ‘conflict of interest’, says former Moody’s boss
Moody’s boss Harrington has harsh words for his former employer.
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Leo Sun is long-time market follower and finance writer. He regularly contributes to the Stock of the Day analysis.
