David Einhorn, a prominent hedge fund manger known for successfully shorting Lehman Brothers, has his sights on his next victim: Moody's (NYSE: MCO). Einhorn recently disclosed that his firm, Greenlight Capital, is shorting the company's stock.
Moody's, for those unfamiliar, is part of the oligopoly of credit rating agencies. Along with Fitch Ratings and Standard & Poor's, the three have virtually exclusive rights to tell the world how to feel about all kinds of debt -- everything from subprime mortgage-backed securities to the debt of sovereign nations.
To be brief -- and polite -- the rating agencies have proven quite bad at what they do. As I explained last week, they conveniently and self-servingly awarded premium ratings to all sorts of explosive debt linked to the subprime housing market. When mortgage-backed securities with top-notch credit ratings went kaboom, the rating agencies' one and only product -- their credibility -- got steamrolled.
But amazingly, the rating agencies are still alive and well. Why? Simple:
- Numerous private investment organizations have bureaucratic rules that force managers to use their services. Since these rules are by and large still in force, investors must use their services whether they want to or not. As Einhorn recently stated, "Nobody I know buys or uses Moody's credit ratings because they believe in the brand. They use it because it is part of a government-created oligopoly and often because they are required to by law."
- As noted, the rating agencies' powers are indeed government-created. In 1975, the SEC created the designation of Nationally Recognized Statistical Rating Organization (NRSRO), which bestowed power on just a handful of rating agencies. Money market funds and broker-dealers are required by law to use NRSRO ratings to guide their capital requirements. This gives the rating agencies powers no sane person thinks they truly deserve.
So, good luck with that
As we've learned with the disintegration of General Motors (NYSE: GM) and legions of other impressive failures, what can't go on forever, won't. Either through regulatory reform or downright investor refusal, the rating agencies in their current form will likely become quite feeble.
And that's where Einhorn's short-selling attack begins. Not unlike his successful bets against Wall Street banks, Moody's is in a business where the odds of disappointment far outweigh the odds of success. In the banks' case, it was insane leverage riding on the hope that real estate could do nothing but go up; In Moody's case, the lurking Achilles heel is a simple projection that investors and regulators will quit paying attention to a company that has thoroughly burned them.
But what makes this short-selling story so intriguing is that Moody's stock is currently priced for perfection. At 19 times forward earnings projections, shares hold a substantially richer valuation than either Microsoft (Nasdaq: MSFT) or Johnson & Johnson (NYSE: JNJ) command. That makes no sense whatsoever.
Furthermore, Moody's balance sheet is quite a brainteaser. As of its most recent quarter, the company had a negative tangible net worth of $1.4 billion. This isn't abnormal for companies that rely on brand-name strength -- both Procter & Gamble (NYSE: PG) and Philip Morris International (NYSE: PM) have negative tangible net worths, too. But what's interesting about Moody's is that the power of its brand name is irreversibly tarnished. The $440 million of goodwill and intangible assets on its balance sheet are likely generous assumptions, based on the greater-fool theory that investors will keep taking its ratings seriously.
The Buffett factor
What also makes this story interesting is that Moody's largest shareholder is none other than Berkshire Hathaway (NYSE: BRK-A). As of the most-recent filing, Berkshire owned 20.36% of Moody's stock.
Since it's essentially never paid to bet against Buffett, some are questioning whether Einhorn's bet is misguided.
And maybe it is, but one point to consider is that Buffett hasn't said anything positive about Moody's in a long, long time. In fact, here's what he told CNBC about Moody's in March 2008:
I don't think there's any question that the intrinsic business value of a Moody's shrunk last year … they have less of a moat around them and they're going to be affected for a long time by the experience of the last couple years.
Asked at this year's Berkshire Hathaway shareholders meeting how he felt about Moody's, Buffett replied, "They made a huge mistake, and the American people made a huge mistake."
That isn't the kind of language you'd like to hear from the company's largest investor.
Bottom line
Is Einhorn right about Moody's? I honestly don't see how he can't be. When former accounting giant Arthur Andersen was exposed after the Enron fiasco, it was forced to shut its doors for good. While the blunders of the rating agencies aren't nearly as scandalous, the outcome shouldn't be too different. When credibility, reputation, and trustworthiness are the only thing you sell, monumental errors of judgment aren't forgiven easily.
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