Why Did Buffett Invest in Moody's?

Why did Warren Buffett let Berkshire Hathaway invest in Moody's Investors Service, given the credit rating agency has a damaged balance sheet and has been running a negative net worth, now at a negative $919 mn?

It's a baffling question for the Oracle of Omaha, renowned for being in the vanguard of the army of Benjamin Graham value investors.

Moody's has reported seven straight quarterly profit declines, it is awash in short-term debt that it's used for billions of dollars in stock buybacks to shore up its shares, and in the process it has levered up its balance sheet at a time when profits are plunging.

Plus, it has been running for a number of quarters on negative shareholders equity of $919 mn. How does a credit rating agency so submerged in debt, with declining earnings, think it can hand out ratings of banks, investment banks and their debt securities when its own financials are in such disarray?

How does a credit rating agency get to operate with a negative book value? Even small broker dealers must have at least $10,000 in net capital to trade.

Warren Buffett's Berkshire Hathaway only just this week cut its stake in Moody's, Bloomberg reports. Buffett sold the shares over three days beginning July 20 for prices ranging from about $28.73 to $26.59, a separate filing said.

Berkshire still holds about 40 mn shares in Moody's, about 17% of the outstanding stock, Bloomberg reports. That's down from just above 20% as of March 31, Bloomberg reports.

Last fall Congress held one of its most heated hearings on the credit crisis, where executives from the credit rating agencies testified.

The agencies, which are not government run, wrongfully gave top notch Triple-A ratings to Kryptonite derivatives (many of them subprime-mortgage bonds) just before that market collapsed. Buffett himself has said Moody's nearly wrecked its brand as its own ratings were proven to be incorrect. The Economist Magazine says: "If the past decade's financial over-engineering was a crime, rating agencies were the getaway drivers."

Congress at the time released internal memos written by executives at Moody's and Standard & Poor's, as well as email exchanges, instant messages, all pointing to how insiders at these companies knew they were botching the job--and did little to stop the worst credit crisis in history from happening.

According to one internal message, Moody's top executive Ray McDaniel wrote that Moody's "analysts and MDs [managing directors] are continually pitched' by bankers, issuers, investors" and sometimes "we 'drink the Kool-aid.'"

The markets have known about this problem for years. The credit rating agencies were painfully slow to warn investors about the problems at Bear Stearns, Enron and WorldCom, just to name a few calamities.

And now this from FT Alphaville, quoting the FT:

Credit rating agencies are back in the spotlight, facing a lawsuit from the largest pension fund in the US over what it says are "wildly inaccurate" ratings and heightened scrutiny from regulators.  The California Public Employees' Retirement System (Calpers) is suing the three leading credit rating agencies over potential losses of more than $1bn related to structured investments that were rated triple A but contained risky mortgage debt.

The lawsuit, filed in a California Superior Court, followed the creation by the Securities and Exchange Commission of a group of examiners to oversee rating agencies. Mary Schapiro, the SEC chairman, highlighted, in Congressional testimony this week, that rating agencies are an area that will likely face heightened oversight.

But it's not just Moody's tattered balance sheet.

Moody's has several serious vulnerabilities, including its fee arrangements, where it gets paid by issuers to rate bonds or other instruments.

Here one of the best stock analysts on Wall Street, who asked to remain anonymous, weighs in:

- The stock price has been held up by company stock buy backs (hence the negative net worth). They have little to no additional firepower to do any more buy backs. In fact, there is a strong argument that they should be going in the opposite direction and deleveraging the company by selling equity in order to retain their license [to operate as a credit ratings agency];

- The analyst goes on to point out the fee model that Moody's has in place as still being rife with all sorts of distortions and conflicts;

- By moving to this model Moody's has figured out a way to "double dip" on fees. Take Mass Mutual as an example. It is now charging Mass Mutual a fee to rate certain investments (the first area that they are trying this model is in syndicated bank type loans). And, then it charges Mass Mutual a fee to rate Mass Mutual [itself], so that Mass Mutual can sell insurance and borrow money. Moody's goes through the portfolio and charges fees for portfolio review as part of the Mass Mutual rating process. So, it charges when Mass Mutual buys and it then charges again when Mass Mutual raises money or sells insurance;

- But, that wasn't good enough for Moody's. They are charging each investor a fee for reviewing the investments. So, a loan that used to have a one-time fee paid by the issuer (of say $1,000,000) is now being charged to each individual investor (at a lower rate to the investor but in the aggregate at a much higher aggregate amount). So, if the loan has 10 investors each investors is being charged a fee of $200,000 and, voila, Moody's has doubled its fees. Needless to say some of the investors are pissed off and starting to make noise with their Congressman. I think that you can call this the "triple dipping fee";

- That wasn't good enough for Moody's. Every time the loan is traded Moody's is charging another fee to the new investor to affirm the rating and they are charging when they evaluate the portfolio of the new investor (like if Mass Mutual trades the loan to Prudential). This is the "quadruple fee" opportunity.

I think it is fair to say that this fee arrangement won't last and the firming up of income for Moody's is probably transient.

- The user-based fee system has another flaw (even if they charge fairly). User-based fees were the system that was used in ALL of the deals that were insured by the monolines. The monolines had all of their deals rated by Moody's and S&P and the monoline paid the fees (not the issuers). Obviously, it was the monolines that crashed first and the ratings of the monolines were all suspect (as were the investments that they made). Investor-paid fees sound like a good idea, but in the economy of 2009 they are worse than issuer-paid fees;

- The securitization revenue stream continues to deteriorate. Recurring fees from securitizations are dropping (as deals amortize off) and aren't being replaced. Securitization was the golden goose for the rating agencies;

-The entire fee system will likely change a lot and the business will be less profitable. As long as the rating fees are volume-based, there are conflicts of interest that are inconsistent with the mission of rating agencies.

The analyst continued: "And, once they are no longer volume-based, the profitability will plunge. As an aside, the mission of the rating agencies is to be accurate, not do a lot of volume. Guess how I think they should be paid."