With the European sovereign debt crisis heating up, rating agencies have once again been slow to respond. However, this alone is not a reason to short rating agencies. Conflicts of interest, the need for financial regulation to maintain demand for their services, loss of efficiency, and the lack of timeliness of their analysis have made rating agencies such Standard & Poor's, Moody's (NYSE:MCO), and Fitch nearly obsolete.
The first problem that will bring down this sector is the inherent conflict of interest with the issuer serving as the customer for credit ratings. With the weakening financial fundamentals of developed governments, politicians will only support the rating agencies if they back up positive claims of the governments' financing. In addition, since rating agencies depend on government mandates of their use to survive, they have perverse incentives to artificially prop up the credit ratings of their sovereign customers. This is probably why rating agencies fail to factor the real payback rate on debt adjusted for inflation. The ability for large, heavily indebted countries with reserve currencies such as the U.S., the U.K., and Japan to pay back debts in nominal terms through monetization is the primary reason that these countries have high sovereign credit ratings. If Moody's and S&P adjusted the payback ratios for inflation, their credit ratings would be several notches lower.
Once their credit rating deteriorates, governments (and, to a lesser extent, banks as well) have the incentive to either discredit the credibility of the rating agency, shop the agencies to find the most favorable result, or to blackmail them into a good credit rating by threatening to change the requirement of their services. An example of this fallout is clearly happening in Europe as lawmakers have already working on passing laws to make themselves exempt from credit ratings. The scrutiny of the U.S. Treasury toward S&P after last year's downgrade also reflects the danger of having a business that relies on regulatory protection.
Even if the business lacked the previously mentioned moral hazard, the track record of rating agencies in recent years has been dismal. During the Enron scandal, Moody's and S&P only downgraded the company's debt below investment grade four days before bankruptcy. The rating agencies also rated several subprime mortgage-backed securities with AAA credit ratings heading into the 2008 financial crisis and were slow to downgrade troubled banks such as Bear Stearns and Lehman Brothers. In the case of the current European debt crisis, rating agencies have been slow to react to the deterioration of creditworthiness of both the sovereign states involved and the banks with exposure to them.
A way to trade the decline of the rating agency would be through shorting Moody's or McGraw-Hill Companies (MHP), which owns Standard & Poor's. Of these two names, Moody's would be the better short because McGraw Hill is heavily diversified in other publishing outlets, such as textbooks. Overall, the flawed incentive system, the risk of governments removing rating mandates (for self preservation), and the poor track record of their risk assessment are all serious weaknesses of the rating agency business that may ultimately drive it into obsolescence.
Disclosure: I am short MCO.