How Badly Damaged Is Moody’s Economic Moat?

Published on September 23, 2009

As one of only a select few ratings agencies granted the status of a “Nationally Recognized Statistical Ratings Agency” by the Securities and Exchange Commission, Moody’s has long enjoyed a significant economic moat.  Obviously, by granting selected agencies official “recognition”, the government bestows an important competitive advantage.  Ratings agencies also have low capital requirements and established “brands” that should result in attractive long term economics.

To say that the economic moats of all the ratings agencies has been damaged over the past year would be a major understatement.  The ratings agencies as a group failed to spot the warning signs leading to the massive economic collapse of late 2008.  Even under the best of circumstances, it would take years to repair the damage done to these brands.

However, at least for Moody’s, it appears that the damage may not have stopped in 2008.  According to a Wall Street Journal article, a former analyst has alleged serious misconduct at Moody’s that may have continued into 2009:

The analyst, Eric Kolchinsky, said Moody’s Investors Service gave a high rating to a complicated debt security in January 2009 knowing that it was planning to downgrade assets that backed the securities. Within months, the securities were put on review for a downgrade.

“Moody’s issued an opinion which was known to be wrong,” Mr. Kolchinsky wrote in a July letter to the rating firm’s chief compliance officer, a copy of which was reviewed by The Wall Street Journal. In the letter, Mr. Kolchinsky cited other instances in which he believes inflated ratings were given to securities.

Obviously these allegations have yet to be proven to be accurate but they cast more doubt on the validity of ratings by calling into question not only the analytical capabilities of the ratings firms but also whether they are operating in an intellectually honest and ethical manner. If proven to be accurate, this is yet another massive blow to Moody’s economic moat and franchise value.

At the Berkshire Hathaway annual meeting in May, Warren Buffett was asked about Berkshire’s investment in Moody’s and he stated that the company still has prospects for reasonable business performance going forward.  However, Berkshire has since liquidated part of the Moody’s position and it is possible that a reassessment of the overall damage to Moody’s economic moat was one of the factors behind the decision.

Disclosure:  The author owns shares of Berkshire Hathaway.

How Badly Damaged Is Moody’s Economic Moat?
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