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Buffett, Einhorn Fight Breaks Out as Government Charges S&P With Fraud

Stocks in this article: MCO MHP MS BRK.A BRK.B GMCR

Updated with closing share prices for McGraw-Hill and Moody's

NEW YORK ( TheStreet) -- The Department of Justice is suing Standard & Poor's, the bond-rating unit of McGraw-Hill (MHP), on fraud charges, claiming it knowingly misrepresented risks in complex and highly rated debt securities before the financial crisis.

Nearly every one of the S&P-rated securities failed, according to the DoJ's civil fraud suit, which calculates the agency may be exposed to repaying least $5 billion in federal government losses. S&P gained from the artificially high ratings, the government said.

While the DoJ's efforts appear to be targeted at S&P, competitors Moody's (MCO) and Fitch Ratings may also face scrutiny. In reaction to a New York Times report and the DoJ's charges, industry analysts said there are risks for all ratings agencies.

Beneath it all is a little-known feud between Warren Buffett's Berkshire Hathaway (BRK.A) and hedge fund investor David Einhorn of Greenlight Capital Management.

It centers on Buffett's near 13% stake in Moody's, Einhorn's short position against the ratings agency, and a class-action lawsuit filed by investors from Iowa, Seattle and Abu Dhabi against it and Standard & Poor's.

The investor lawsuit against Moody's and S&P is set to unfold in courtrooms this month and may indicate whether firms will face an onslaught of private claims, or whether they will put some litigation risk behind them, as booming debt markets create a strong pipeline of business for ratings agencies.

The investor lawsuit filed in 2008 by Abu Dhabi Commercial Bank and Washington's King County argues Moody's and S&P knowingly misrated a structured investment vehicle (SIV) for Morgan Stanley, which the bank then sold off to unwitting investors who suffered losses shortly thereafter.

The SIV, called "Cheyne," contained notes backed by supbrime mortgages and it received the "highest credit ratings ever given to capital notes," according to the judge presiding on the case.

Those notes failed during the credit crunch, and plaintiffs argue the securities were knowingly misrated by agencies because of high fees paid by the issuer, Morgan Stanley, which is also a defendant in the case. Investors are now litigating Moody's and S&P for fraud in a last push to hold the agencies accountable.

The suit centers on whether private investors can be paid out over claims of misrepresentation on the shoddy ratings ascribed to complex securities. Moody's and S&P, meanwhile, argue that their ratings stand as an opinion protected under the First Amendment of the U.S. Constitution, not a guarantee.

The private lawsuit, which is similar to the DoJ's civil fraud complaint against S&P unveiled Tuesday, is likely to either put to bed investors' claims for pre-crisis bond ratings -- or open a Pandora's box of liability that goes beyond the government's suit.

In September, a ruling by U.S. District Judge Shira Scheindlin on the lawsuit against Moody's and S&P's casts doubt on whether ratings opinions can be protected by First Amendment free speech rights if a fraud can be proven.

After the ruling expunged all but a fraud charge against Moody's and S&P on the Cheyne SIV, Einhorn said at the Value Investing Congress in October 2012 that the suit could subject ratings agencies to legal issues that would destroy their business models and financial position this year.

"It's a matter of time before they all disappear," Einhorn said of the rating agencies in response to an audience question asking for an update on his short thesis on Moody's. A similar suit on a SIV called "Rhinebridge" that was rated by Fitch, Moody's and S&P may also go to trial after a Jan. ruling from Judge Scheindlin

In a Jan. 22 investor letter, Einhorn noted the poor performance of Greenlight Capital in the fourth quarter, and attributed the fund's woes to a backfiring short position in Green Mountain Coffee Roasters (GMCR) and the falling shares of Apple (AAPL). Einhorn didn't mention a short position in Moody's in the letter. A voicemail left with a Greenlight spokesperson wasn't immediately returned.

In Tuesday trading, McGraw-Hill shares fell over 10% to close at $44.92 as details on the DoJ's suit were released. Moody's shares were down nearly 9% in Tuesday trading.

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