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S&P, Moody's Face an 'Existential Threat'

Stocks in this article: MCO MHP MBI BAC

NEW YORK ( TheStreet) -- How bad could it get for ratings agencies Standard & Poor's (owned by McGraw-Hill (MHP)) and Moody's (MCO) now that the Department of Justice is suing S&P on fraud charges and state attorneys general including Eric Schneiderman of New York appear to be ready to dig in for a legal fight?

Many on Wall Street appear to feel renewed scrutiny on the bubbly pre-crisis ratings handed out by the likes of S&P and Moody's will fizzle, just like toxic real estate and structured securities they gave high ratings to.

Still, firms face an "existential threat," as the prospect of federal and civil fraud charges on pre-crisis ratings overhangs the bond-rating industry, according to Mark Palmer, an analyst at brokerage firm BTIG.

In fact, Palmer sees ratings agencies facing the same risks as Arthur Andersen, the accounting firm that failed in the wake of the bankruptcy of Enron, which imploded because of widespread accounting fraud.

The conflict of opinion is highlighted both in Moody's earnings Friday and a brewing battle between Warren Buffett's Berkshire Hathaway (BRK.A) and David Einhorn of Greenlight Capital Management.

Moody's reported fourth-quarter revenue rose 33% to $754.2 million, while operating income increased by an even greater 51%. Still, the rating agency's impressive numbers amid an end-of-year bond-market surge didn't impress investors, and Moody's shares fell.

The selloff likely has more to do with reports from Bloomberg and Reuters that the DoJ may yet consider a suit against Moody's and that state attorney generals are already preparing litigation.

So how bad could it get?

BTIG's Palmer says S&P, Moody's and Fitch Ratings may eventually disappear if federal or civil fraud charges are proven. That's what happened to Enron's auditor, Arthur Andersen. The key, according to Palmer, is that a potential admission of fraud would render the opinions of an agency worthless.

"We believe a fraud conviction would not only be a threat to the agencies' business prospects, but an existential threat as well. Talk about downside risk," Palmer writes in a Feb. 7 note to clients.

Notably, Palmer sees the prospect that the demise of pre-crisis industry leaders comes as a result of emerging competition, a scenario many appear to consider unlikely.

"Some have argued that Moody's and S&P , which have a virtual oligopoly in the credit-ratings space, are too large and too ingrained in global finance to simply go away," Palmer says.

"We believe that if one or both of the firms went the way of Arthur Andersen, then upstart rating agencies with untarnished reputations such as Morningstar, Kroll and A.M. Best could rise up to take their place," the analyst said.

Palmer, who appears to be sifting through the remnants of post-crisis muck on Wall Street for contrarian investment recommendations, sees potential legal risks as more extreme than Bank of America (BAC), which is laden with litigation centered on the housing bust.

Currently, Palmer sees a positive outcome for monoline bond insurers such as MBIA (MBI) in winning legal battles against the banking industry for toxic securities.

"BofA will settle, Moody's is facing a different set of circumstances," Palmer said in an interview Thursday, noting that any admission of fraud by a rating agency would open the door to a flurry of litigation.

That mirrors the argument of Einhorn, a noted short-seller who's ruffled the feathers of tech giant Apple (AAPL) in recent days.

While the DoJ's efforts appear to be targeted at S&P, for now, it and competitors Moody's (MCO) and Fitch Ratings will face scrutiny in civil fraud lawsuits set to hit courtrooms this month.

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