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McGraw-Hill (MHP), the financial services conglomerate and the owner of the largest rating agency in the world, Standard & Poor's, has a past of consistent business performance and high shareholder value generation. But some recent events have quickly changed the scenario and now threaten the future existence of the company.

The most important among these is the allegation by U.S. Department of Justice or DoJ that the rating arm of the company, S&P, has been involved in manipulating ratings of a large number of mortgage bonds, misleading investors and playing a major role in the creation of the largest economic crisis in the U.S. since the 1933 slowdown.

The higher credit ratings given by major rating agencies before the crisis ensured very high investment (upwards of $3.1 trillion) in highly risky mortgage bonds which later on defaulted and became worthless. The DoJ is seeking close to $5 billion in damages to investors and other financial institutions and is holding the company partially responsible for the crisis which followed. Also, the recent decision by McGraw-Hill to sell its education business has not impressed many analysts and it is claimed that the sellout is going to adversely affect the cash flow of the company.

Ironically, Moody's (NYSE:MCO), the biggest rival of S&P, has recently downgraded the company by two notches to Baa3, which lies in the speculation category and is only two notches above the junk category, from A3 and has given a negative outlook for the future.

Discriminatory Ratings?

S&P is a highly coveted organization in the economic statistical market majorly due to its status as Nationally Recognized Statistical Ratings Organization (NRSRO). This makes the ratings provided by the firm highly reliable and dependable for both investors and companies willing to raise money from the market through various investment instruments. In fact, given the complexity of investment instruments such as Mortgaged Backed Security (MBS) and Collateralized Mortgage Obligation (CMO), investors tend to exclusively rely on the credit ratings provided by agencies such as S&P.

During 2007, the market was flooded with subprime mortgages such as MBOs and CMOs which were backed with the highest debt rating of 'AAA' from various rating agencies. Most of these bonds defaulted during the so called bursting of mortgage bubble which led to the economic meltdown in 2008.

It is indeed baffling that while S&P has only rated 4 companies out of 2000 companies in the U.S. whom it tracks with the highest rating of AAA, it ended up giving the same rating to hundreds of these mortgage-based bonds even without proper paper evidence in some cases. S&P claims that these ratings were given on the basis of objective and sound technical analysis and they were not able to predict the future possibility of a default.

If looked closely, these schemes were indeed promising on the surface given that they were backed by federally owned government institutions which made them appear less risky than they actually were. Also, it is easier for a bond to achieve such ratings as the rating agencies tend to favor their clients who are the issuers of those bonds and their paymasters.

No matter what the lawsuit results into, it can't be good news for McGraw-Hill investors as the damage to the reputation of the company will be irrecoverable, making it difficult to add new clients and maintain existing ones. If we couple this with the selling of the education business, things indeed look bleak at least in the short term.

Last quarter for the company as a whole has been disappointing. The business turned to loss equating to $216 million or 76 cents a share compared to a profit of $214 million, or 73 cents a share in the corresponding quarter last year. The company wide revenue increased to $1.23 billion, up from $1 billion last year. If we divide the results in different business segments, the financial arm of the company did well as new bonds issuance has picked up pace in recent times. Revenue has increased by 34% to $584 million.

However, to continue the same trend in the future, the company needs to tread well against various lawsuits filed against it which seem like a complex task. The history is definitely in favor as most of these cases in the past have been either revoked or settled outside the court. But this time the DoJ seems more than determined to put its words across which might lead to more stringent settlement terms.

Competitor Scenario

To assume the government retaliation will remain limited to S&P will be very naïve given the fact that all major rating agencies are stakeholders in providing ratings to mortgage based bonds. Moody's and Fitch, which have been quick in their assessment of McGraw-Hill's future prospects, may as well be next to come on the crosshair of the DoJ. For Now, the solo action against S&P is being seen as the retribution against S&P's downgrade of US government's credit rating in 2011 which increased the borrowing cost for the government. But the next move in the pipeline is from the New York state attorney general who is planning a case of his own which might not be limited to S&P. He has made it clear that he is not going to limit his options and may even end up filing a criminal case which will make life more difficult for these agencies.

The future of the ratings business depends on the outcomes of these lawsuits. For McGraw-Hill in particular, the rating arm has been its soul savior in difficult times. After discontinuation of the education business, the cash flow balance is slated to deteriorate unless the company comes up with a better future restructuring plan. Given the threat to its major arm, S&P, this is a very difficult task indeed.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: McGraw-Hill: Creditworthiness In Question