Last week, just as the Fool ran my short piece on the regulatory risk to Fannie Mae's (NYSE:FNM) and Freddie Mac's (NYSE:FRE) government-ceded duopoly, Congress moved on a bill that threatens another such duopoly: that of the nationally recognized statistical rating organizations, or NRSROs; in laymen's terms, recognized credit ratings agencies. The House passed the Credit Rating Agency Duopoly Relief Act of 2006, which now requires a vote in the Senate.
The Securities and Exchange Commission began the NRSRO designation in 1975 for agencies whose ratings could be used by banks and broker-dealers to determine how much of what kind of capital they were required to hold. Regulatory use of credit ratings has since expanded: They are now used in selecting securities for money market and state pension funds, for example. There are five NRSROS; of these, Moody's Investors Service, a unit of Moody's (NYSE:MCO), and the Standard & Poor's division of McGraw-Hill (NYSE:MHP) have an 80% market share.
There's a formidable barrier to achieving the NRSRO designation because the most important criteria is whether the organization is "nationally recognized as an issuer of credible and reliable ratings by the predominant users of securities ratings." This creates a Catch-22 for new entrants, for how are they to achieve national acceptance without the credential they cherish?
Combine the competitive advantage the designation confers with an asset-light business model, and you have the recipe for tremendous profitability and returns on capital. With operating margins of 54% and return on equity of 134% on a trailing-12-months basis, Moody's trounces Microsoft (NASDAQ:MSFT) on both those measures. Little wonder then that Moody's largest shareholder is Berkshire Hathaway (NYSE:BRKa) (NYSE:BRKb), with a 16.5% stake on March 31.
In light of the top firms' dominant position and haunted by the collapse of Enron and WorldCom, Congress now feels that the market for providing credit ratings needs to be opened up. Lawmakers are concerned that the recognized agencies didn't foresee these massive bankruptcies and that the cross-selling of other services to issuers could compromise the integrity of the ratings system. The current bill would allow any ratings agency that has been in business for three years to apply for the NRSRO designation by providing the SEC with information on its ratings methodology and procedures for handling conflicts of interest.
While this all seems laudable, it's not at all clear that increasing the SEC's power of oversight over ratings agencies is an effective means of protecting investors or altering the structure of the industry. Issuers prefer to deal with a limited number of agencies to reduce search costs. Similarly, investors have come to rely on the large brand-name agencies, and rightly so, because the academic data suggests their ratings have been good predictors of bankruptcy and changes in credit quality over the long haul.
The market rarely rewards increased regulation, but it may be overly pessimistic concerning the ultimate economic impact of this bill. Based on Monday's closing price, Moody's shares have lost almost 30% since the end of the first quarter. Value investors who love the company but always felt the shares looked pricey may yet find a buying opportunity.
Moody's is a Motley Fool Stock Advisor recommendation. Fannie Mae and Microsoft are Inside Value selections. Are you interested in finding other great companies that are trading at a temporary discount? Analyst Philip Durell will do the job for you: Find out more by taking a30-dayfree trial to Inside Value.
Fool contributor Alex Dumortier has a beneficial interest in Microsoft but none in any of the other companies mentioned in this article. He welcomes your (constructive) feedback. The Motley Fool has a strict disclosure policy.
