NEW YORK (Reuters) - Shares of Moody’s Corp (MCO.N) fell sharply on Thursday after hedge fund manager David Einhorn, who correctly questioned the health of Lehman Brothers four months before its collapse, disclosed he was shorting the venerable ratings agency.
Einhorn, whose Greenlight Capital managed $5 billion, said on Wednesday the parent of Moody’s Investors Service undercut the value of its primary business — assigning grades to bonds — after giving AAA ratings to insurer AIG (AIG.N), mortgage banker Fannie Mae FNM.N, bond insurer MBIA Inc (MBI.N) and other companies later revealed to be badly overextended.
Moody’s has also come under fire for granting its top rating to mortgage-backed securities and derivatives later found to be built on sketchy, subprime loans.
“If your product is a stamp of approval where your highest rating is a curse to those that receive it, and is shunned by those who are supposed to use it, you have problems,” Einhorn told some 1,200 hedge fund executives at the annual Ira Sohn Investment Research Conference.
Moody’s shares fell as low as $25.69, its lowest in more than a month, before trading down 5.5 percent at $26.58 on Thursday afternoon. Options traders also reacted to the bearish comments.
“Given the nature of our business, which is to offer forward-looking opinions about future credit risk, the role of independent public opinions about market participants such as Moody’s is well understood by us,” said Moody’s spokesman Tony Mirenda. “Moody’s opinions are a valuable source of information and continue to be widely sought by market participants of all kinds.”
The bearish view sets up a battle between Einhorn and legendary investor Warren Buffett, whose Berkshire Hathaway Inc (BRKa.N) is Moody’s largest shareholder. For now, the market is lining up behind the boyish hedge fund manager with a growing reputation for spotting overvalued companies.
“Investors are piling up bets that shares in Moody’s will fall at least 22 percent over the next six weeks,” said Andrew Wilkinson, senior market analyst at Interactive Brokers Group.
Wilkinson said buying in July $20 strike puts more than doubled to 65 cents per contract. Overall, puts have outpaced calls by 4.5 to 1 during the first half of Thursday.
“Investors appear to be taking their cue from his theory that the ratings business model is flawed and the services of these companies are redundant, Wilkinson said.
Einhorn contends that investors have learned not to rely on Moody’s, which for years has been criticized because it earns fees from the companies it rates. And after the mortgage market melted down in 2007, Moody’s came under fire for giving top grades to bonds and derivatives backed by subprime loans.
“The truth is that nobody I know buys or uses Moody’s credit ratings because they believe in the brand,” he said at the conference, which raises funds for the treatment and cure of pediatric cancer. “They use it because it is part of a government-created oligopoly and, often, because they are require to by law.”
Even Buffett, Einhorn added, has said he does not rely on credit ratings when making investments.
Yet Einhorn noted that equity investors still believe in the agencies. Moody’s shares trade at a rich 19 times estimated earnings, he said, though he said the company has a negative net worth of $900 million.
Moody’s had long been a favorite among investors because the limited number of firms approved by the U.S. government to rate debt lets these firms generate fat profit margins. McGraw-Hill Cos Inc’s MHP.N Standard & Poor’s and Fimalac SA’s LBCP.PA Fitch Ratings are Moody’s rivals.
Immediately after his presentation, Einhorn told Reuters he began thinking about Moody’s and the quality of credit ratings in 2002, when fellow activist William Ackman started shorting MBIA. He declined to say when he began shorting Moody’s, only noting it was a “considerable” amount of time ago.
Regulators and lawmakers for years talked about reforming the ratings system, questioning the issuer-funded business model that critics say conflicted with the interests of investors who buy company debt, municipal bonds or asset-backed securities. Einhorn called for sterner measures.
“Why reform them if we can get rid of them?” he said. “Are we waiting for then to blow up the Lunar economy as well?”
Einhorn used the Ira Sohn event seven years ago to announce a short position on business lender Allied Capital Corp ALD.N, questioning the values it assigned to assets and sustainability of its dividend. Allied, which in February defaulted on a credit line and in March suspended its dividend, recently announced its fifth straight quarterly loss.
And at last year’s conference, Einhorn set off a firestorm when he boldly accused investment bank Lehman of understating its losses on real estate assets and for not holding enough equity capital.
After weeks of heated denials, Lehman raised $6 billion of capital to offset mounting write-offs. Within four months it filed the biggest bankruptcy in U.S. history.
In related news, Einhorn closed the book on his Allied transaction and made good on a promise to donate the firm’s profits from the trade to charity.
He announced that Greenlight would donate $2.5 million to Tomorrows Children’s Fund, on top of $1 million donated to the charity four years ago, as well as $1.8 million each to two government watchdog groups: the Center for Public Integrity and the Project on Government Oversight.
Reporting by Joseph A. Giannone; Additional reporting by Doris Frankel in Chicago and Jon Stempel in New York; Editing by Richard Chang, Dave Zimmerman, Tim Dobbyn