Capital Markets

Moody’s CEO Fires Back at Lawsuit, Details Grim Quarter

Responding to a Connecticut complaint that the agency underrates municipals, McDaniel reports the toll of the credit crisis on his company.
David KatzJuly 30, 2008

Adding to his prepared remarks for what was already a rather grim second-quarter earnings call for the ratings agency, Raymond McDaniel, the chairman and chief executive officer of Moody’s Corp., fired back on Wednesday at a lawsuit filed by Connecticut Attorney Richard Blumenthal.

Blumenthal, who filed similar suits against McGraw-Hill (the parent company of Standard & Poor’s) and Fitch Inc., charged that Moody’s uses “a different and far more difficult rating scale for public bonds, as compared to corporate bonds” in order to improve the marketability of its ratings and appeal to sophisticated investors. The rating agency did this despite its own findings that municipal bond rates had lower default rates than corporate bonds, he contends.

Contending–with the demurral that he had not read the complaint yet–that the suit was “utterly meritless,” Moody’s McDaniel told analysts that “asserting that a rating scale is wrong is the equivalent of saying that measuring distances in centimeters is wrong or measuring in inches is right.” The agency “isn’t irrevocably committed to any measurement system because measurement systems do not relate to rating accuracy,” he added, noting that Moody’s publishes municipal and corporate ratings side by side “so investors can make an informed decision about relative credit risk.”

Further, McDaniel assured listeners that Moody’s municipal rating analysts and managers “have been reminded to consider only matters pertaining to credit issues” because “investors may construe the Connecticut attorney general’s actions as an attempt to influence Moody’s to upgrade the rating of the state of Connecticut.”

The CEO already had his hands full with the job of reporting and explaining bad quarterly news. Fueled by a precipitous drop in its ratings business, Moody’s as a whole reported revenue of $487.6 million for the three months ended June 30, 2008, a decrease of 25 percent from $646.1 million for the same quarter of 2007.

Revenue at the Moody’s Investors Service–the company’s ratings business–for the second quarter of 2008 was $355.8 million, however, representing a decrease of 33 percent from the prior-year period. Of that U.S. revenue decreased 42 percent, to $198.8 million, for the second quarter of 2008 from the second quarter of 2007. In contrast, non-U.S. revenue of $157 million, representing 44 percent of total MIS revenue, declined just 17 percent from the same quarter in 2007.

The collapse of the market for structured finance in real estate has apparently taken its toll. Within Moody’s ratings business, global structured finance revenue totaled $120 million for the quarter, a dive of 56 percent from a year earlier. U.S. structured finance revenue decreased 67 percent, “driven by significant declines in issuance across most asset classes, the company reported in a release.” Non-U.S. structured finance revenue decreased 35 percent, led by declines in the European credit derivatives and commercial real estate finance sectors.”

Moody’s said that it expects its revenues for rating U.S. structured finance business for the year “to decline in the high-fifties to low-sixties percent range, reflecting large double-digit percent declines in most asset classes, led by residential mortgage-backed securities, commercial real estate finance and credit derivatives ratings.”

Although the credit crunch will cool down the agency’s U.S. corporate-finance business, the decline will be less steep than it will be in structured finance, the company expects. “In the U.S. corporate finance business, we now expect revenue to decrease in the mid-twenties percent range for the year, driven by declines in speculative-grade bond and bank loan ratings,” it said.

In June, the Securities and Exchange Commission, proposed new rules that would govern Moody’s and its two major competitors, S&P and Fitch. Responding to an analyst question McDaniel said that he didn’t think that the agency’s compliance with some of the proposals wouldn’t be material, largely because Moody’s had already reflected some of the costs in its financials. However, he said, “the proposals from the SEC are wide-ranging” and the expenses for the ones requiring the rating agencies to put report information in machine-readable format “could be materially higher than the expectations in Washington” hold them to be.

Another analyst wondered what standing Blumenthal, the Connecticut attorney general, had to sue Moody’s. In response, McDaniel said that under the law governing the rating agencies they’re subject to SEC oversight rather than that of the states. While the company is incorporated in Delaware and headquartered in New York City, Blumenthal’s complaint states, Moody’s derives “substantial revenue from its business within the State of Connecticut.” From 1998 through the present, the agency provided over 345 credit ratings in at least 85 cities and towns in the state and rates the many public bonds issued by it.