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.
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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.
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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.
Sees Strong Full-Year Profit
Moody's did not address the concerns in its earnings statement, in which it focused on its forecast for a strong year ahead. Moody's and S&P have benefited as firms refinance debt to take advantage of rock-bottom interest rates to access cheap funding.
Moody's corporate finance business rose 73 percent to $244.9 million in the latest quarter.
The company said it expects full-year earnings in the range of $3.45 to $3.55 per share and revenue growth in the high single digits percent range.
Analysts on average were expecting the company to earn $3.18 per share, excluding items, according to Thomson Reuters.
"The legal fears are overshadowing what is a stellar 2013 outlook. I think the fears are overblown, but that's my opinion," Benchmark Co analyst Edward Atorino said.
However, Moody's signaled that the growth in its Investors Service unit, which houses the bond rating business, is set to slow. The company forecast full-year revenue growth at the unit in the high-single-digit percent range, compared with the 20 percent rise in 2012.
Revenue from structured finance — the rating of complex bonds such as collateralized loan obligations and commercial mortgage-backed securities — is expected to grow in the mid-single digit percent range for the full year.
The complicated debt structures were blamed for magnifying the chaos caused by the subprime mortgages and issuance fell after the crisis.
But as the consumer and auto loans are increasingly being bundled into securities in the United States, the fortunes at the business are turning around.
U.S. structured finance revenue grew 50 percent in the fourth-quarter.
Net income in the quarter rose to $160.1 million, or 70 cents per share, in the fourth quarter, from $96.2 million, or 43 cents per share, a year earlier.
Revenue rose 33 percent to $754.2 million.