VideoLater this month, the Securities and Exchange Commission — courtesy of the Sarbanes-Oxley Act of 2002 — will issue a report on the state of credit-rating agencies. The subject of two days of congressional hearings in November, the SEC's report will likely address transparency in the rating process, fee structures, and what impact increased competition will have in an industry dominated by the Big Three — Standard and Poor's Corp., Moody's Investors Service, and Fitch Ratings.
At venerable Standard and Poor's, president Leo C. O'Neill has little doubt the SEC will act. Given the immense pressure on the agency to restore investor confidence, and the intense criticism of rating agencies in the wake of recent accounting scandals, action is inevitable, he says. What troubles the 63-year-old O'Neill is that the SEC may go too far in reining in the raters, since, as he says, "this is a system that essentially works in terms of risk identification — credit-risk identification."
That system, which is designed to judge the creditworthiness of corporate borrowers, has been working for almost a century, he explains. As he testified at the public hearing, at his firm (a division of The McGraw-Hill Cos.), "...all our processes, our standards, our methodologies are geared to meeting the objectives of integrity, quality, objectivity, credibility, and independence."
Critics charge, however, that the system broke down in the case of Enron, which both S&P and Moody's listed as investment grade just days before the energy trader filed for bankruptcy. When the Senate Governmental Affairs Committee issued its report on Enron in October, it said that the raters failed to ask probing questions about Enron's financial condition — a charge that goes to the heart of what such agencies do.
It's the labeling of his firm as a watchdog that especially irks O'Neill. Congress contends that as designated NRSROs — nationally recognized statistical rating organizations — Standard and Poor's and the other raters have some responsibility to detect wrongdoing. But "the designation is just a description of the role we play," O'Neill insists. "The system is not geared to uncover fraud."
As it waits for the SEC's report, and the directives that may result, Standard and Poor's has taken several steps to shore up its own reputation. In October, for example, the firm launched a corporate-governance ranking system that will evaluate board independence and procedures. In conjunction with that, it released a new transparency study that ranked the S&P 500 according to the disclosures made in their financial statements.
O'Neill, who started at Standard and Poor's in 1968 as an analyst in its Equity Services Division, sat down with CFO deputy editor Lori Calabro before the hearings to discuss some of these steps. A follow-up interview in early December solicited his reactions to the hearings and pending industry changes.
The Senate Governmental Affairs Committee's report blamed the rating agencies along with the SEC and the analysts for Enron's failure. Was that fair?
Obviously S&P and the other rating agencies were evaluating Enron, so it was fair enough to include us. My view is that the report ascribed a watchdog role to S&P that no one, including us, ever intended S&P to have. That's not our job. We are recipients of the information that is generated by the companies, approved by their auditors, and sanctioned by their legal counsel. We believe we have every right to rely on the disclosures they make to the SEC. We also, as you know, meet with companies and ask them a lot of questions. But quite honestly, they have absolutely no obligation to disclose to us. And we have no right to impose any kind of sanctions or legal constraints [to make them disclose].
Congress might argue that because of your NRSRO status, you are a watchdog.
The role of watchdog [belongs to] market regulators and supervisory authorities, not rating agencies. Our job is to determine credit risk, not to police the markets. The phrase "NRSRO" was first used in 1975. The SEC used the term to encompass all of the agencies, but they used it with small "n," small "r," small "s," small "r," small "o." It was a description, not a certification of the agencies at that time. We've been rating bonds since the turn of the century without any special powers either before or after we were designated an NRSRO.
But given that many money-market fund portfolios must hold securities with NRSRO investment-grade ratings and that the designation has been cited in governmental guidelines such as the Basel Accords, doesn't that give you a quasi-regulatory role?
NRSRO opinions have been embedded into a variety of regulations. But that does not mean that the rating agencies have a regulatory role. Ratings tell you the relative credit risk. Ultimately, the investment manager or the bank or whoever has to make the call as to whether that risk is one they can manage.
The SEC will soon issue its report to Congress. Speculation is that the agency may recommend more regulatory oversight. Can anything good come out of that?
The SEC has had a dialogue with S&P about the role of rating agencies for 25 or 30 years. We've had any number of conversations about how we rate companies, how we manage our conflicts of interest, etc. And they've always come back and said [they] have no problems with how S&P operates. I don't think the SEC wants to back into the rating business or become the rater of the raters. Because if it does that, it becomes the court of appeals, and I don't think it wants to do that either.
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