“In the coming year, the Securities and Exchange Commission will complete its examination of the [nation’s rating agencies] role in rating residential mortgage-backed securities and collateralized debt obligations linked to subprime mortgage loans.”

So said the SEC in a June 2008 report.

That wasn’t fast enough for the nation’s largest pension fund, which said it lost more than a billion dollars because of bad ratings. On July 9th, it sued Moody’s Investors Service (NYSE: MCO), Fitch Ratings and McGraw-Hill’s (NYSE: MHP) Standard & Poor’s unit. The case, which will be heard before a jury, is scheduled for its first conference in early December.

CalPERS, the California Public Employees Retirement System, invested $1.3 billion in mortgage-backed securities by buying debt issued by three entities whose sole function was to use borrowed money to buy mortgages. When the housing market collapsed and the resultant subprime crisis emerged, the investment lost hundreds of millions of dollars in value.

Moody’s, Fitch and S&P had all given the debt their highest credit ratings, indicating a low likelihood of default. In a remarkably clear explanation of a complicated financial transaction, CalPERS’ lawyers lay out their case against the ratings agencies, alleging they were not only incompetent in rating the debt but also did so under a conflict of interest that rewarded lax standards. The suit includes damning excerpts from ratings agency employees warning that the ratings were far too lenient. An S&P analyst wrote, “Let’s hope we are all wealthy and retired by the time this house of cards falters.”

The wealthy part the ratings agencies managed to get.

Moody’s, for example, has been the most profitable company in the S&P Index for the past five years (as measured by operating margins). S&P and Moody’s earned three times more for grading some debt obligations than they would for rating typical corporate bonds. “The revenue from structured finance grew +800% from 2002 to 2006,” the lawsuit notes.

In recent years, one of the most important changes in the industry involved the way the agencies were paid in the first place. For years, their compensation came from subscriptions they sold to investors. Now, however, they are paid by the entities issuing the debt — and those fees are contingent upon its successful sale in the marketplace. The higher the rating, the higher the fees — a difficult conflict of interest to explain, and certainly a tough thing to sell to a jury.

It’s unclear what CalPERS is looking for with the lawsuit. The large pension fund ate the loss, and though it doubtlessly would like to have is $1.3 billion back, the pension fund – which is often characterized as an “activist” investor — may be more interested in proving its point and seeking to effect a sea change in how ratings are granted, paid for and used within the financial system. Certainly regulators are interested, too. It seems inevitable that someone ultimately will be held to account for the subprime woes, and the lawsuit makes an outstanding case that the ratings agencies would be a good place to start. CalPERS has all but unlimited resources to pursue the lawsuit. None of the ratings agencies want to go to court. If I were a pension executive, I wouldn’t be in any hurry to cut a deal. CalPERS is holding all the cards.

Moody’s doesn’t have the cash on hand to make CalPERS whole. The company has $6.9 billion in market cap. It took in $1.75 billion in revenue last year, earning a net profit of $457 million. It has $245 million in cash on hand and $1.4 billion in debt. Shareholder equity is negative, meaning it has more debt than assets, a strange position for such a profitable company to find itself in.

Moody’s counts legendary value investor Warren Buffett among its shareholders. Buffett’s holding company, Berkshire Hathaway (NYSE: BRK-B) holding company owns 48 million MCO shares worth $1.4 billion. Buffett has said that if there was any wrongdoing at the company, the people responsible for it should leave.

Moody’s shares now carry enough litigation risk that they are no longer suitable for risk-averse investors. McGraw-Hill, S&P’s parent, now also shoulders this risk, as does Fitch, a unit of a French company – Fimalac. CalPERS’ lawsuit was filed in Superior Court in California on July 9.

Moody’s is trading at 16.4 times earnings, about its historical average. Its return for the year is an eye-popping +43.8%. Given those numbers, there isn’t any upside left. Investors who own either shares in Moody’s or McGraw-Hill should liquidate the positions and seek something safer.