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Credit Watch

S&P's Leo O'Neill to SEC: We are not the watchdogs.
A CFO Interview, CFO Magazine
January 1, 2003

Later 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.


Could something ill come of this?
If you ask me what kind of pressure the SEC is under to do something, I suspect it's fairly considerable. They had hearings in 1997, where they asked the same questions and came up with a list of recommendations. They weren't very onerous from our standpoint. They dealt with how you become an NRSRO and what it means to have an NRSRO role. [This time], I guess, it's going to be much more process-oriented, in terms of how we operate and what we tell them.

There are calls to give additional companies the NRSRO designation. What's your position on increased competition?
We welcome it. But the designation carries responsibilities, including the need to maintain the people, systems, processes, and credibility that go along with it. The primary criteria for NRSRO designation should continue to be preexisting market recognition and market use of ratings.

The Senate committee's report on Enron charges you failed to ask probing questions about its financial condition.
We did ask. We finally [demanded] a listing of all the off-balance-sheet financing vehicles they had and the risks surrounding them. They provided us with a document that purported to be "everything and the kitchen sink." It was, of course, woefully inadequate.

So are you accountable at all?
Should we have spotted the fraud? I don't know. My view is that we were not charged with uncovering that fraud. We had a BBB+ rating on this company when it was the seventh-largest company in the United States. That's a correlation that just doesn't fit. I don't think we were misleading investors.

How will you guard against being gamed going forward?
How many times have we seen the system really gamed? Companies by and large are playing it legitimately. Obviously, companies don't want to tell us every piece of bad news. No, we probe and they tell us, because they know with the rating agencies, at least with S&P, they are going to have an ongoing dialogue.

Post-Enron, have your credit-rating procedures changed?
Certainly, over the past few years with the growth of financial engineering, special-purpose entities [SPEs], off-balance-sheet financing, etc., we are putting greater emphasis on accounting practices and financial engineering. Second, we are looking very closely at our rating review process to ensure we are timely, accurate, and still take into account all the relevant factors for rating surveillance. Third, we are looking at new and enhanced credit-risk models to help us in the surveillance process. These, we think, may be able to give early warning signals about companies in trouble in terms of the likelihood of downgrades or default. Fourth, we have recently completed a survey on 1,000 companies to see if there are so-called rating triggers that may impact on their creditworthiness. We have found that there were fewer than 30 worrisome situations globally. Of course, we are monitoring this closely.

In terms of disclosure post-Enron, how forthright are companies these days about off-balance-sheet entities?
Companies that employ [these] techniques are very forthright. Many of those vehicles are rated by S&P. There's no hiding them so much as there is disclosing how these vehicles are used. And many of them [exist] to maximize the efficiency of a company's balance sheet and how it finances its operations. So to go after off-balance-sheet financing is the wrong direction. Maybe there needs to be more disclosure about it — in some regulatory filings or annual reports — but it's a financing technique with great legitimacy.

Are they being weighted differently in the credit ratings?
Overall, our analysis is based on the economic substance of the transactions, specifically the risks and financial obligations retained by the operating company, and not on the accounting treatment.

FASB is set to restrict the use of SPEs. What impact will that have on the number of off-balance-sheet entities you rate and how you rate them?
There is a very positive role that securitization plays in capital markets. Off-balance-sheet financing, SPEs, and so on can be very useful, but it is best if they are also transparent. I'd hope that any new accounting proposals in this area would not rule out the benefits of this kind of transaction, thereby making it unacceptable.

S&P recently joined the crowded field of corporate-governance raters. Is there a relationship between corporate governance and credit ratings?
Does good governance equal good credit? Not necessarily. You can be governed just wonderfully and get killed by the competition. But, clearly, companies that are governed poorly usually don't get very good ratings. In our credit analysis, we've always looked at how a company is being governed, how good its management is, and whether it has a strong track record of credibility.

Will your governance ratings eventually be incorporated into credit ratings?
The work we're doing regarding public documents will be made available to our credit-rating people. However, this highly interactive corporate-governance report we'll be preparing for corporations will [remain] between the corporation and S&P. We would hope, though, that this process would become embedded and most corporations would make the outcomes available to the public.


What if you found something that was material to the credit rating?
If there were something truly material to the credit rating, it would probably be material to the price of the stock. So our first [question] would be, "When are you going to disclose that publicly?" And if a corporation says, "We're not going to," then we have an obligation to say, "We're going to report it to the SEC." It's hard to imagine a situation, though, that would come up in our analysis of corporate governance that would not have been part of the credit-rating disclosure.

You said recently that if there weren't improvements made in governance, we could see another major firm implode.
Nirvana would be a marketplace where implosions can occur, mistakes can be made, but the market and the integrity of the market remain intact. We are not there yet. Will [all the reform efforts] be able to prevent implosions in the future? I doubt it. There are going to be companies that get themselves into trouble.

In your recent transparency study, you came down hard on annual reports. But CFOs would say you have to also look at other financial filings to get a full picture of a company.
I don't disagree. However, in most cases, if you look at the annual reports alone — the one document most easily accessible and understandable to individual investors — you are not likely to find important information about how a company governs itself, how much senior officers are paid, how audits are conducted, or who the top shareholders are. In other words, critical information is generally not disclosed in those reports.

CFOs might argue that you could find much of this information in the footnotes or in other filings.
I can find a good doctor in the Yellow Pages, too. Help me out here!

Indications are that we will soon see an avalanche of new disclosures. How durable will this new openness be?
Therein lies the risk, no? The attitude becomes, "This, too, shall pass." And quite honestly, even the many U.S. corporations that are playing the game properly may take that stance. They are absolutely going to adhere to Sarbanes-Oxley and some of the other reforms, but in terms of their outreach to third parties — maybe, maybe not. The risk is that companies have that attitude and then there is another implosion. The risk of that occurring should be in the back of everyone's mind.

A recent survey by the Association of Financial Professionals found that almost 30 percent of finance executives do not believe their companies' debt ratings are accurate.
I would say that about 100 percent of all batters who strike out think the call was wrong, too... We are very interested in what anybody — media, regulators, corporations, investors — thinks about our processes. We encourage that dialogue. On the other hand, when issuers resist, I think that's to be expected. And I think the more interesting question is to ask if you think the process is fair.

Those same financial executives also complain about the timeliness of getting ratings changed.
Usually, CFOs want the process slowed down. Bond investors, on the other hand, want it sped up. Too fast, too slow; too high, too low. It's almost a mantra. And I'll tell you, when all these disparate interests come to disparate conclusions, I'm led to believe the process is just right.

Since companies pay for ratings, there is obviously a potential for conflicts of interest. Still, you haven't suffered as much backlash as, say, the investment banks or the auditors. Why?
No smoking gun.

What do you mean by that?
We manage the heck out of that process. First, we separate S&P's business interests from its analytical interests. No analyst has a financial stake in the outcome of his or her rating judgment. Second, all ratings are assigned by a committee, so you don't get a Henry Blodgett type of thing. Third, we have a code of ethics, which every employee signs, dictating the behavior of independence and objectivity. And surrounding all of that is the understanding of our people that the longevity of this enterprise rests solely on our ability to do what we do with the highest level of integrity. We have been charging for ratings since 1968 and I don't think you'll find a trace of an aroma of misdoing around this process.

Reflecting on the past year, is it safe to say the role of the credit-rating agency has changed?
Not because of Enron. Certainly because of the spotlight. But [that spotlight has been turned on] before: the late 1960s and 1970s with Penn Central, mid-1970s with the fall of New York City, the early 1980s with Chrysler, late 1980s and early 1990s with the junk-bond debacles. What it creates is a healthy look at what rating agencies do and how we do it. But it's also a reminder of the trust that we have with investors and issuers. And we've got to do everything possible to make sure we don't abuse that trust.

Going to the Core

To S&P President Leo C. O'Neill, "the idea of identifying the true earning power of a corporation is like the Holy Grail of security analysis." And to that end, the rating agency introduced "core earnings" last May — its attempt to go where the brave dare not go.


The new metric differs from how companies normally compute earnings in three key ways: it excludes income from pension plans, treats stock options as an expense, and recognizes restructuring charges. And while O'Neill admits that core earnings is "certainly not GAAP," he believes that it more accurately measures the underlying performance of today's corporations. Stock options were not such "an issue 10 years ago," he says. "Pension plans were not an issue, unless you were analyzing Ford Motor, General Motors, or Chrysler. But we've come out with a metric that takes these things into account. We think it relates expenses to revenues in the most appropriate way."

The concept, however, guarantees — at least in today's economy — that corporate earnings will be lower. In a recent report calculating core earnings for the S&P 500, in fact, S&P found its figures were about 31 percent lower than reported earnings for the year ending last June.

Not surprisingly, such figures have not enamored the metric to many companies. Some have dismissed core earnings as just another version of pro forma. And to date, no company — including S&P's parent, The McGraw-Hill Cos. — has used the metric in its earnings releases.

O'Neill is undeterred. "We think it's the best standard. If we're right, over time investors will be drawn to it. And if that occurs, eventually corporations will start providing the metric." —L.C.




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