Over the past 40 years US Secretary of Defense Donald Rumsfeld has been gathering snippets of wisdom for a rulebook he is compiling. One of the most frequently quoted axioms in this book is: “If you are not criticized, you may not be doing much.”
This should provide some degree of consolation to Leo O’Neill, who as president of Standard & Poor’s has been forced to respond to no small amount of criticism. Rating agencies have, after all, been subjected to the most fearsome tongue-lashings from any number of critics in recent years. From their failure to foresee the Asian crisis to their tardiness in responding to the Enron and WorldCom fiascos, the rating agencies have become the punch bag of an entire market.
A verdict delivered in the wake of the Enron failure by the report of the Staff of the Senate Committee on Governmental Affairs was unusually forthright. That report advised that the agencies’ “monitoring and review of [Enron’s] finances fell far below the careful efforts one would have expected from organizations whose ratings hold so much importance”.
O’Neill responds: “To me, the interesting thing is that the criticism we receive in the US revolves around whether or not we’ve been doing a good job as far as investors are concerned. The questions are: did we rate Enron too high? Did we lower the rating quickly enough, blah blah blah.”
O’Neill points out that there is nothing novel about S&P being subjected to a barrage of criticism. “This is not strange territory,” he says, launching into an impromptu history lesson about the relationship between S&P’s founder, Henry Varnum Poor, and the famously bullish publisher and editor of the New York Tribune, Horace Greeley.
Greeley, an exponent of the ‘Go West, Young Man’ doctrine of the 1850s and 1860s, took Poor to task for having the temerity to alert investors to the risks associated with the construction of the railroads and canals in the middle of the last century. Poor’s cautious stance was much to the disgust of those who – like some of the dot.com equity analysts of the late 1990s – saw dollar signs behind every new project. Individuals like Poor may have sounded like wet blankets, but they injected a voice of reason.
“I don’t want to be glib about it, but frankly that is what S&P has to do, and what S&P does well,” says O’Neill. “Just as Henry Varnum Poor did, we alert investors to the risk of default, and investors will make the decision as to whether or not to invest based upon those risks.”
In other words, this is the oft-repeated argument that the rating agencies do nothing more – and nothing less – than express their opinions in accordance with the terms of the First Amendment. Strip away that right, which O’Neill likes to equate with the right of financial journalists to express their opinions, and a so-called “chilling” effect would transform the agencies’ research into little more than homogenous spreadsheets of statistics.
Fair enough. But herein, surely, lies one of the most difficult conundrums associated with the role played by rating agencies today. While the market may accept that the agencies act exclusively as presenters of opinion which investors may or may not choose to agree with, the truth of the matter is that like it or not their opinions often function as facts.
It is, for example, a fact rather than an opinion that scores of institutional investors will have to sell a security downgraded to non-investment grade territory regardless of whether or not they agree with the fundamental argument behind the downgrade. It is a fact rather than an opinion that in the vast majority of cases a downgrade will result in (or be anticipated by) a widening of spreads. It is a fact rather than an opinion that an additional consequence of a downgrade will be an increase in borrowing costs for the issuer concerned. It all amounts to a lot of power for organizations arguing that they merely express opinions.
“I draw issue with your basic premise,” is O’Neill’s response to this series of arguments. “Shortly after I joined S&P, everything you’ve said would have been true. In the late 1960s and early 1970s when S&P or Moody’s lowered a company’s rating from BBB to BB or from Baa to Ba, the impact on the marketplace was huge. Management would feel it had fallen from financial favor into financial disgrace overnight.”
And when downgrades happened, they tended to drag the rest of the market down with them. “Look what happened in the commercial paper market when Penn Central went bust. The whole CP market evaporated,” says O’Neill.
Today, O’Neill argues that markets have developed a level of depth, liquidity and sophistication to ensure that this sort of thing no longer happens, and that a spectacular collapse (whether triggered by a ratings change or not) will not be sufficiently influential to spread contagion elsewhere.
Perhaps. But however minimal the agencies’ overall influence may appear to be – and many would argue that O’Neill is vastly underestimating their influence today – there is no question that they have been put under more intense scrutiny over the last two years than during any other period in living memory. Much of that scrutiny would have arisen with or without Enron, because many of the questions posed by regulators and by the designated agencies’ increasingly aggressive competitors have nothing whatsoever to do with Enron, WorldCom, the Asian crisis, or any of the other financial collapses that the agencies failed to anticipate.
Take the issue of the relationship between analysts at rating agencies and their largest institutional clients. In its report on the role of the agencies, published in January 2003, the SEC uses some truly delightful euphemisms to describe this relationship. Subscribers, it says, may have direct access to rating agency analysts for “elaborative conversations” which may in turn lead to “unfair information asymmetry in the marketplace”.
In his testimony to the House Financial Services Committee, delivered in April, Sean Egan dispensed with euphemisms of this kind. The managing director of Egan-Jones Ratings explained bluntly that in the present environment “some investors, particularly large investors, are given information on analysts’ opinions in advance of others.”
This is an exceptionally serious allegation, made all the more so by the fact that agencies are privy to non-public information, a privilege about which investors still feel deeply uncomfortable. In the words of Cynthia Strauss, director of taxable bond research at Fidelity Investments: “The fact that rating agencies have access to information that investors cannot have creates great concern for us.”
On this thorny issue, O’Neill is unequivocal in his response. Do some investors have access to important information in advance of others? “That’s not true and the market knows it’s not true,” he says. “If the question is: can investors call S&P and ask why we rated something in the way we did, or what we meant by a certain phraseology, we would say, absolutely, this is a transparent organization.”
But surely if an analyst says anything – a single word – to an investor which adds something to a piece of published research, doesn’t that analyst open himself to the charge of providing “elaborative” detail which may or may not result in the dissemination of “unfair information asymmetry”? Absolutely not, says O’Neill. “No analyst will disclose any information to any outsider that would create an advantage for that outsider,” he insists.
What of O’Neill’s response to other concerns about the role of the agencies, which would have continued to rumble in the background with or without Enron? One of these is the potential for severe conflicts of interest that arise from the provision by the agencies of a range of ancillary advisory services, such as pre-rating assessments and corporate consulting.
As the SEC’s report observes: “Concerns have been expressed that credit ratings decisions might be impacted by whether or not an issuer purchases additional services offered by the credit rating agency.” It adds: “Some believe that, whether or not the purchase of ancillary services actually impacts the credit rating decision, issuers may be pressured into using them out of fear that their failure to do so could adversely impact their credit rating.”
O’Neill says that for one thing, ratings advisory services are only provided to companies that are already rated. He also says that this service is one that S&P has provided for decades without giving rise to uncomfortable questions about conflicts of interest. For years, he explains, the rating scenario advice service was one that was provided by investment banks in an era in which the capital market remained more relationship-based than transaction-based. With the passing of that era, more and more demands have been made of the rating agencies to advise on how individual companies’ ratings would be affected by raising, say, $500 million of short-term facilities in the CP market.
“We told companies we would be ready to help them with that advice but that in many cases it would involve a great deal of time, work and effort and so we would expect to be compensated for that,” says O’Neill. “But many companies see the advisory service as being part and parcel of the ratings process itself.”
A trigger for change
So much for items of detail. What of the bottom line? Will the aftermath of the Enron episode and the scrutiny to which the rating process has been subjected result in any substantial change to the regulatory framework within which the agencies operate? O’Neill appears to believe not. On the subject of the official designation enjoyed by a handful of the top rating agencies, only Moody’s has indicated that it would support a move by the SEC to eliminate the label of Nationally Recognized Statistical Ratings Organization (NRSRO) which many say has created a government-sanctioned oligopoly.
“I believe that if we weren’t officially designated, the market would continue to use our ratings just as heavily as it did in the past,” says O’Neill, adding that the experience of history supports that belief. When S&P, alongside Fitch and Moody’s, was given NRSRO status back in 1975, he says, it was not because the agencies solicited the status. It was a response by the SEC to the market’s demand for officially and nationally recognized agencies, and the designation given to Fitch, Moody’s, and S&P was merely in response to those organizations’ track records. “Our view is that the quality of our ratings created the designation, not the other way round,” says O’Neill.
The NRSRO’s fiercest critics might well argue that the agencies’ track records in recent years are a pale shadow of what they were in the mid-1970s. But O’Neill reiterates his belief that the use of NRSRO ratings are now so firmly entrenched that the disruptive influence of the removal of the designation would be considerable.
“We believe that because the designation has now been embodied in so many rules and regulations, if it were dropped it would not have much impact on us,” he says. “But we also believe that it would be disruptive for a lot of investing institutions and fiduciaries.” Unwittingly perhaps, that view echoes a favorite observation by a London-based head of credit research who has repeatedly expressed the view that if agencies ceased to exist, the market would need to invent new ones.
While O’Neill is a staunch advocate of rating agencies, he originally had no intention of becoming such a dyed-in-the-wool member of the credit markets. In 1968, having graduated with a BA in economics and political science from Hobart College in Geneva, New York, he joined Standard & Poor’s as a trainee equity analyst, fully expecting to move onward and upward after a short stay at the rating agency.
“It was a little bit like the early 1990s,” he recalls. “We were in the middle of a bull market, the Street was doing extremely well and personnel turnover levels were high.” O’Neill freely admits that like many other young graduates arriving on the Street in the late 1960s, he planned to cut his analytical teeth at S&P for as long as it took, and then move into the glamorous and highly paid world of broker-dealers – “with Merrill Lynch or Goldman Sachs or whatever.”
The economic fallout from the Vietnam War put paid to that particular ambition. The inflationary spiral of the early 1970s, says O’Neill, paralyzed and destabilized a bond market which for years had been a stable and unexciting component of the US capital market. “We went into a period of very severe crisis in the credit market, as a result of which all of a sudden this thing that S&P and Moody’s was doing, called credit ratings, became very visible. I moved over to the bond market in the early 1970s because I recognized that it was going to be an important growth area for S&P.”
Today, that might not sound like having been an especially insightful prediction. But at the time, as O’Neill says, by far the largest part of S&P’s business was equity research. Fixed-income research remained very much a poor relation, with no more than a “handful” of people involved in the S&P ratings franchise, compared with 2,300 to 2,400 worldwide today. That meant that O’Neill found himself at the right place and at the right time to make an important contribution to the rapid expansion of S&P’s ratings business. By the mid 1970s, he was head of ratings, and by the end of the 1990s he had been appointed president of the firm.
Three-and-a-half decades of service to a single firm in an industry not noted for the loyalty of its staff have clearly left O’Neill with a profound affection for S&P and a passionate belief in the role played by rating agencies in the capital market.
“I love this place,” he says. “I love what we do. And if I’m somewhat protective, it is because I know – I know – that what we do and the way we do it is right. I’m 63 and I’m not going to be hanging around here for another 35 years, but sometimes I wish I could be, because I think our business is going to become even more exciting and more visible.”
And his service has not been entirely thankless: O’Neill was recently admitted into the Hall of Fame of the Fixed Income Analysts Society (FIASI), although he modestly insists that this is less a reflection of his own contribution to the market and more of the broader achievements of S&P over the last 35 years.
As to O’Neill’s own plans, colleagues say that even after 35 years with S&P, it would be a mistake to assume that he is ready to bow out now that he is in his early 60s. His non-professional ambitions of bringing his golf handicap down from 12 to single figures, and of devoting more of his time to the Hudson Valley environmental conservation group that he is now involved in, may both have to be set on ice for a number of years yet.
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