Rating Firms’ Next Subprime Role

By Aaron L. Task | Editor at Large @ thestreet,com | 8/23/2007 10:53 AM EDT

As the carcasses of subprime mortgage-backed securities lie rotting on Wall Street, the buzzards are circling heretofore untouchable prey: the rating agencies.

Critics say the ratings industry was too late in downgrading mortgage-backed securities, echoing cries after past crises involving Enron, WorldCom and Russian debt, among others. But the current episode comes with a different twist: Rather than merely third-party observers, some sources say Moody’s, Standard & Poor’s and their smaller rival Fitch Ratings played active roles in structuring MBS and related securities. Therefore, they could be deemed underwriters and exposed to legal liabilities for the sector’s unraveling.

“The chances no one is preparing cases [against the rating agencies] is very small,” says Sylvain Raynes, a former Moody’s structured finance analyst and principal at R&R Consulting, which specializes in credit metrics and the structured finance market. Unlike traditional corporate bond offerings, rating agencies “have to be involved in the structuring [of asset-backed securities] because otherwise the deal does not happen. There is nothing before the rating. It would be nonsense if they were not involved.”

Shares of Moody’s and McGraw-Hill are each down more than 25% year-to-date, due to the potential for heightened regulatory scrutiny and a hit to earnings as the “credit crunch” leads to fewer structured deals to rate. Moody’s earned about $3 billion from rating structured deals from 2002 through 2006, and the area accounted for 44% of its 2006 revenue, The Wall Street Journal reported.

But beleaguered shareholders should brace themselves for some serious headline risk — beyond what’s already occurred. Largely absent from the public discussion to date — including the Journal’s story and a similarly themed front-page piece in The New York Times — is the potential legal liability facing the rating agencies.

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