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S&P, Moody's Face an 'Existential Threat'

Tickers in this article: BAC MBI MCO MHP

Currently, Palmer sees a positive outcome for monoline bond insurers such as MBIA(MBI) in winning legal battles against the banking industry for toxic securities.

"BofA will settle, Moody's is facing a different set of circumstances," Palmer said in an interview Thursday, noting that any admission of fraud by a rating agency would open the door to a flurry of litigation.

That mirrors the argument of Einhorn, a noted short-seller who's ruffled the feathers of tech giant Apple(AAPL) in recent days.

While the DoJ's efforts appear to be targeted at S&P, for now, it and competitors Moody's(MCO) and Fitch Ratings will face scrutiny in civil fraud lawsuits set to hit courtrooms this month.

The DoJ claims S&P knowingly misrepresented risks in complex and highly rated debt securities before the financial crisis.

A seperate multi-year investor lawsuit against Moody's and S&P is set to unfold in courtrooms this month that may indicate whether the firms will face an onslaught of private claims, or whether they will put some litigation risk behind them, as booming debt markets create a strong pipeline of business for ratings agencies.

The suit filed in 2008 by Abu Dhabi Commercial Bank and Washington's King County argues Moody's and S&P knowingly misrated a structured investment vehicle (SIV) for Morgan Stanley , which the bank then sold to unwitting investors who suffered losses shortly thereafter.

The SIV, called "Cheyne," contained notes backed by supbrime mortgages and it received the "highest credit ratings ever given to capital notes," according to the judge presiding on the case.

Those notes failed during the credit crunch, and plaintiffs argue the securities were knowingly misrated by agencies because of high fees paid by the issuer, Morgan Stanley, which is also a defendant in the case. Investors are now litigating Moody's and S&P for fraud in a last push to hold the agencies accountable.

The suit centers on whether private investors can be paid out over claims of misrepresentation on the shoddy ratings ascribed to complex securities. Moody's and S&P, meanwhile, argue that their ratings stand as an opinion protected under the First Amendment of the U.S. Constitution, not a guarantee.

The private lawsuit, which is similar to the DoJ's civil fraud complaint against S&P unveiled Tuesday, is likely to either put to bed investors' claims for pre-crisis bond ratings -- or open a Pandora's box of liability that goes beyond the government's suit.

In September, a ruling by U.S. District Judge Shira Scheindlin on the lawsuit against Moody's and S&P cast doubt on whether ratings opinions can be protected by First Amendment free-speech rights if a fraud can be proven.

After the ruling expunged all but a fraud charge against Moody's and S&P on the Cheyne SIV, Einhorn said at the Value Investing Congress in October 2012 that the suit could subject ratings agencies to legal issues that would destroy their business models and financial position this year.