Monitor the Rating Agency Lawsuit

 | Feb 07, 2013 | 2:00 PM EST  | Comments
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mhp

,

mco

Over the past five days, shares in McGraw-Hill (MHP) have declined 22% and shares in Moody's (MCO) have slipped 13%. If you have missed the headlines, the U.S government has decided to sue Standard & Poor's (S&P), the rating agency that is wholly owned by McGraw Hill. As expected, the shares immediately dropped on the news.

Right now, it's far too early to gauge or even properly handicap what the possible outcomes are going to be. S&P has already prepared itself for a long, costly battle by hiring one of the top white-collar defense lawyers in the country. But we all know Mr. Market hates uncertainty, and I suspect that over the coming weeks -- and, perhaps, months -- the continued uncertainty will continue to anchor the shares. Such uncertainty often leads to equities being mispriced, which can lead to investment opportunities.

The credit rating industry has only three major credit rating providers: S&P, Moody's and Fitch. These three agencies account for a near 95% market share. Every credit instrument requires a rating in order to be priced. And credit is like the central nervous system of the global economy. What if that system gets sick or is damaged? Well, we saw what happened in 2008.

Credit is here to stay; therefore, so is the need for credit agencies. I think the big, broad-stroke concern that will arise from this lawsuit is whether or not the market will benefit from having more competitors. One of the biggest criticisms to come out of the financial crisis was that the dominant position of the Big Three played a significant role in sloppy rating practices. Although it's not yet on the table, I wouldn't be surprised if Uncle Sam decides credit ratings should be issued by the government. Actually, a more palatable solution is that such agencies would fall under government supervision. That scenario seems likely to be part of the ultimate settlement agreement.

I wouldn't necessarily be discouraged by this, especially if the share prices continue to decline. The financial industry is subject to greater regulatory oversight today and, at the right prices, the big banks have been fantastic investments. One thing is for sure: This is only the beginning of what could be take a year or more to resolve. Mr. Market is a  moody fellow who probably can't be very patient. This could lead to further declines. At the height of the financial crisis, Moody's shares fell to $16 -- they trade for $47 today; McGraw-Hill shares fell to $17 and they trade for $44 now. If we start seeing prices like that again, you can thank both Uncle Sam and Mr. Market for serving up a fat pitch.

The best policy now is to pay attention to the news, follow the operating performance of these companies and keep an eye on the valuation. It's been proven time and time again that market turmoil creates some of best opportunities to seize on phenomenal, above-average investment gain.

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