S&P, Moody's Face an 'Existential Threat'
NEW YORK ( TheStreet) -- How bad could it get for ratings agencies Standard & Poor's (owned by McGraw-Hill(MHP) ) and Moody's(MCO) now that the Department of Justice is suing S&P on fraud charges and state attorneys general including Eric Schneiderman of New York appear to be ready to dig in for a legal fight?
Many on Wall Street appear to feel renewed scrutiny on the bubbly pre-crisis ratings handed out by the likes of S&P and Moody's will fizzle, just like toxic real estate and structured securities they gave high ratings to.
Still, firms face an "existential threat," as the prospect of federal and civil fraud charges on pre-crisis ratings overhangs the bond-rating industry, according to Mark Palmer, an analyst at brokerage firm BTIG.
In fact, Palmer sees ratings agencies facing the same risks as Arthur Andersen , the accounting firm that failed in the wake of the bankruptcy of Enron, which imploded because of widespread accounting fraud.
Moody's reported fourth-quarter revenue rose 33% to $754.2 million, while operating income increased by an even greater 51%. Still, the rating agency's impressive numbers amid an end-of-year bond-market surge didn't impress investors, and Moody's shares fell.
The selloff likely has more to do with reports from Bloomberg and Reuters that the DoJ may yet consider a suit against Moody's and that state attorney generals are already preparing litigation.
So how bad could it get?
BTIG's Palmer says S&P, Moody's and Fitch Ratings may eventually disappear if federal or civil fraud charges are proven. That's what happened to Enron's auditor, Arthur Andersen. The key, according to Palmer, is that a potential admission of fraud would render the opinions of an agency worthless.
Notably, Palmer sees the prospect that the demise of pre-crisis industry leaders comes as a result of emerging competition, a scenario many appear to consider unlikely.
"Some have argued that
"We believe that if one or both of the firms went the way of Arthur Andersen, then upstart rating agencies with untarnished reputations such as Morningstar, Kroll and A.M. Best could rise up to take their place," the analyst said.
Palmer, who appears to be sifting through the remnants of post-crisis muck on Wall Street for contrarian investment recommendations, sees potential legal risks as more extreme than Bank of America (BAC) , which is laden with litigation centered on the housing bust.