Shares in credit rating agency Moody's fell sharply on Friday as the prospect of a federal fraud lawsuit over its pre-crisis debt ratings overshadowed a 66 percent rise in quarterly earnings and a strong 2013 outlook.
The Justice Department and multiple states are discussing suing Moody's for defrauding investors, people familiar with the matter told Reuters, but any such move will likely wait until the lawsuit against rival Standard & Poor's is tested in the courts.
Last week, the U.S. government launched a $5 billion civil suit against S&P and its parent, McGraw-Hill, over mortgage bond ratings.
On a conference call Friday, Moody's CEO Raymond McDaniel said he does not have any knowledge about the Justice Department raising similar claims against Moody's.
"If the question has become when, and not if, a lawsuit will be filed against Moody's, then the shares are simply unbuyable, in our view," BTIG analyst Mark Palmer said.
Moody's already faces fraud claims filed from private investors. Abu Dhabi Commercial Bank, King County in Washington state, and other investors are suing the firm over losses in Cheyne, a structured investment vehicle.
Moody's and S&P have long faced criticism from investors, politicians and regulators for assigning high ratings to thousands of subprime and other mortgage securities that turned sour.
"I don't know how a portfolio manager can explain why he was holding the stock when this legal Damocles is hanging over Moody's," Palmer said.
Sen. Richard Blumenthal, D-Conn., told CNBC that S&P's defense will likely rest heavily on First Amendment protection of freedom of speech. "But that defense is diminishing in its strength because courts have held that ... the First Amendment does not provide them with the kind of blanket absolute immunity they claim," said Blumenthal, a former state attorney general.