Capital Markets

Good to Rate

The rating agencies are under review for their failure to downgrade Enron more promptly. The only trouble is, proposed reforms might make things wo...
Tim ReasonSeptember 4, 2003

Sean Egan does not mince words. In letters to Congress and in interviews, the president of credit-rating agency Egan-Jones Ratings Co. compares his competition to “thugs” and “criminals.” In a formal filing with the Securities and Exchange Commission, he argues that reforms aimed at Standard and Poor’s, Moody’s Investors Service, and Fitch are as pointless as requiring a mugger to explain himself to his victims. “It does not offset his robbing you.”

“My language is harsh,” concedes Egan, “but we don’t see any way around the problems [with rating agencies] without going to the root cause” — by which he means the fact that most rating agencies are paid by the companies they rate rather than by the investors who use the ratings.

Egan has an ax to grind: his small, 14-analyst firm lacks the coveted NRSRO (nationally recognized statistical rating organization) status the government bestowed on S&P, Moody’s, and Fitch. Those firms, despite greater resources and hundreds of analysts, hesitated to downgrade Enron and WorldCom until the collapse of those companies was almost a certainty. Egan-Jones, which is funded by investor subscription, dropped Enron below investment grade a month before it collapsed, and rated WorldCom as junk for almost a year before it went bankrupt.

Today the NRSROs are facing the same intense regulatory review that forced enormous changes on the accounting and investment-banking industries. A U.S. Senate committee report concluded that “the rating agencies’ approach to Enron fell short of what the public had a right to expect.”

But despite apparent parallels with audit firms and the investment banks, it is not clear exactly what the large rating agencies did wrong. True, they missed some major corporate meltdowns, but were they corrupt, incompetent, or simply cautious? “[There’s] no smoking gun,” S&P president Leo O’Neill told CFO in an interview earlier this year (see “Credit Watch,” January). “All the scrutiny and review for the last 15 to 16 months have revealed absolutely no wrongdoing by Moody’s or any credit-rating agency,” adds Moody’s president Ray McDaniel, “which is unique among all the sectors that have been investigated by authorities over the last few months.”

Even the SEC doesn’t seem to know exactly what problem it is trying to fix. As a result, it’s far from clear what actions it will take to shore up investor confidence in ratings, or how its actions will affect the rating agencies’ relationships with companies. Egan is not sanguine about the outcome: “What will probably come out of this is the recognition of some additional NRSROs, and then a continuation of business as it has been conducted over the past 25 years.”

A Fine Distinction

The NRSRO designation consumes much of the debate over what, if anything, to do. Back in 1975, the SEC required securities dealers to evaluate their risk using ratings, and specified some acceptable ratings providers, or NRSROs. The unintended result of this move was a government-sanctioned — and unregulated — oligopoly of S&P, Moody’s, and Fitch.

Critics say this designation has become a barrier to entry into the rating business. There’s no formal definition of what an NRSRO should be (it was, after all, meant to describe existing firms) and no official process for becoming one, although the SEC occasionally names new NRSROs. Dominion Bond Rating Service was given the status in February. Egan-Jones, on the other hand, has been waiting five years for a nod.

SEC commissioners are reportedly split over whether they should address the perceived failures of rating agencies by regulating NRSROs or simply by eliminating the designation (thereby opening up the business to broader competition).

Either move is problematic. The NRSRO term has become so enshrined in banking and securities regulations that doing away with it would be an enormous legislative headache, and could destabilize other investor protections. In addition to the SEC’s regulation of net capital requirements for broker-dealers, some eight federal statutes, 47 federal regulations, and more than 100 state laws and regulations rely on NRSRO ratings. And that’s not counting thousands of private contracts and even international laws that have also adopted the term.

Alone among its peers, Moody’s says it would support an SEC move to eliminate the NRSRO label, and adds that this would silence critics who say the SEC’s blessing stifles rating-industry competition. But Moody’s might simply be calling its critics’ bluff — it’s not alone in pointing out that NRSRO status was created for the convenience of regulators, not rating agencies. S&P, with considerably less brinkmanship, notes dryly that such a move could be “disruptive to the market.”

It seems more likely, therefore, that the SEC will formalize the NRSRO application process. But doing so means establishing regulatory requirements and oversight. That could encourage newcomers by clarifying what it takes to join the industry. On the other hand, if the new rules enshrine the business models of S&P and Moody’s, they would further marginalize firms like Egan-Jones.

The Watchdog That Didn’t Bark

The larger question, of course, is not NRSRO status, but why the rating agencies’ access to inside information didn’t help them anticipate the financial collapses of Enron or WorldCom. (Although the current NRSROs all happen to use confidential meetings with management in their credit analyses, all credit-rating agencies are allowed such access by Regulation FD, as long as they don’t selectively disclose the inside information.)

Should the major credit-rating agencies have smelled trouble at Enron and WorldCom? In his interview with CFO, O’Neill said S&P relies on the accuracy of a company’s financial reporting to the SEC and added, “The role of watchdog [belongs to] market regulators and supervisory authorities, not rating agencies.”

“If a company is trying to mislead the marketplace, it’s highly unlikely that [it is] going to use the rating agency as a confessional,” explains McDaniel. By now, he notes, most CFOs have probably experienced Moody’s renewed focus on liquidity analysis, and an added emphasis on accounting, governance, and risk transference. Nonetheless, he says, “we are cautious about saying we can [detect] fraud on a systematic basis.”

Critics scoff at the idea that insider information is essential to understanding company creditworthiness but useless in terms of detecting fraud. Perhaps the more pertinent question raised by the current debate is whether rating agencies need inside access at all.

“Could we form a credit opinion without the Reg FD exemption? Yes,” says McDaniel. Likewise, O’Neill says discussions with senior management should not be a requirement for NRSRO status, noting that “it is possible to perform a high-quality credit analysis relying solely on publicly available information of an issuer.”

Now, as a direct result of Enron, a lot more is publicly available, including data on off-balance-sheet arrangements, contingent liabilities and commitments, contractual obligations, and guarantees. “The impact of all [the transparency] initiatives,” notes one SEC staff report, “should be to enhance the ability both of rating agencies and investors to evaluate the credit quality of issuers.” If so, are the benefits of inside access worth perpetuating the false impression among investors that inside access helps detect fraud?

In Praise of Volatility

Of course, the large rating agencies claim there are other benefits to sitting down with management. Without such conversations, says McDaniel, “ratings are likely to be more volatile and less considered [because] we will have to react to public information very quickly.” That, he predicts, would lead to more short-term rating reversals — something Moody’s tries hard to avoid. “I suppose there is nothing theoretically wrong with a more volatile ratings system,” he says, “but institutional investors and the issuer community [tell us] that rating stability is valuable.”

Egan argues that such meetings contribute to an overly cozy relationship between credit analysts and companies. “You see what the company wants you to see,” he says. That, he adds, is a corrupting influence that compounds the issue of how the big agencies are compensated and explains why Egan-Jones was able to call some impending financial collapses well ahead of the NRSROs.

McDaniel counters that “niche credit-rating agencies” can be quick to change their ratings because those changes don’t carry the same consequences as a downgrade by Moody’s and its peers. “Because the influence of our actions can be so material in the marketplace,” he says, “having less judicious or deliberative ratings can be damaging.”

To be sure, Egan-Jones’s prediction in March that Ford Motor Co. was close to bankruptcy caused turmoil in the bond market. But is that so damaging? Moody’s and S&P were more reassuring, and in the end, investors had a useful variety of analyses on which to base their decisions.

A Level Playing Field

That’s one reason the NRSRO debate must be handled so carefully. Moody’s and Fitch, for example, argue that widespread, free dissemination of ratings should be an absolute requirement for any agency seeking NRSRO status, in large part because agencies privy to inside information should not selectively disclose it to subscribers. (That thinking might be one reason why the SEC hasn’t awarded NRSRO status to Egan-Jones, although the SEC’s informal NRSRO guidelines make no mention of this requirement.) But if widespread dissemination were required, it would make NRSRO status impossible for subscriber-based firms such as Egan-Jones, even though that firm does not use nor want inside information.

McDaniel of Moody’s reacts in horror to the idea of NRSRO status for subscriber-based agencies, citing the dangers of “front-running.” This argument is hard to sustain, given that Egan-Jones’s products don’t use inside information and are already available in the market. Moreover, Egan-Jones does provide its ratings to anyone who asks, and S&P and Moody’s both offer subscription-level services that, according to an SEC report, entail their own potential risk of selective disclosure. Likewise, Egan’s argument that “rating agencies should be weaned away from issuer compensation” may be too drastic a solution, since no one can prove that ratings were corrupted simply because companies paid for them.

All this suggests that the answer is not for the SEC to bless a particular business model — which aggressive regulation of NRSROs would likely do — but rather to do its best to level the playing field. To some extent, the recent reporting reforms are a big step in that direction. While a formal definition of NRSROs seems likely, the SEC should strive for a light touch that will allow agencies a choice of business model and a choice of how to deal with Reg FD. Then Egan won’t have to convince the government that his competition is corrupt; he’ll simply have to convince his customers that his ratings are better.

Tim Reason is a senior writer at CFO.

More Agencies, More Headaches?

“We think [insider access]is an accident waiting to happen,” says Sean Egan, president of rating agency Egan-Jones, which does not meet with companies or use inside information in its credit analyses. “We don’t want the liability,” he says.

Despite the risk of information leaks alluded to by Egan, most financial executives don’t seem particularly concerned that most rating agencies are privy to inside information. Without that access, testified Ford Motor Co. treasurer Malcolm S. McDonald during Securities and Exchange Commission hearings last fall, “there is no way that we would release confidential product plans for future years, which could be used by our competitors. So applying the exemption from FD, I think, improves the rating process.”

“We share very proprietary information” with the rating agencies, agrees General Motors Corp. assistant treasurer Sanjiv Khattri, who is responsible for his company’s relationship with all four NRSROs (nationally recognized statistical rating organizations). “If anything, we give them more information than they want. We have no reason to believe that our trust has ever been violated.”

But insider access could prove to be a headache for CFOs if the SEC succeeds in boosting the number of competing rating agencies. Indeed, one of the more worrisome issues for companies is whether newcomers would build their business by issuing unsolicited ratings, which could seem like an effort to blackmail companies into paying for and participating in a rating process.

Citing “hostile reactions,” Moody’s Investors Service’s response to the SEC’s concept release says it has “almost completely curtailed the assignment of unsolicited ratings in recent years.” By contrast, Standard and Poor’s, which rates all issuers of public debt valued at more than $50 million, asserts that “the market also benefits from a process that does not allow management the option of shielding itself from the analysis of any particular rating agency.” Fitch (which, despite its NRSRO status, depicts itself as an upstart battling a “dual monopoly” of S&P and Moody’s) vigorously defends the practice, noting that unsolicited ratings are consistent with others it issues, “although the level of management involvement varies.” Here again, access to management and inside information is apparently not essential to the rating agencies, although Fitch defends cutting companies off for nonpayment on the grounds that they “often do not provide adequate information for the agency to maintain the rating.”—T.R.

Shorted by Long-term Thinking

Whatever changes may be in store for credit-rating agencies, there’s one problem that Jerome Van Orman doesn’t think will be fixed. For more than a decade, General Motors Acceptance Corp.’s (GMAC) CFO of North American operations has complained that ratings for long-term corporate bonds and commercial paper (CP) are inconsistent. “I’ve been on this for 10 years,” he told Congress last year. “I’m down to talking to the family dog about it.”

Since the 1970s, commercial paper has been rated on a simple three-point scale from Tier-1 to Tier-3 (Standard and Poor’s and Fitch also use a Tier-1 designation for particularly safe commercial paper). But Van Orman believes rating agencies tend to think long-term and simply base CP ratings on established correlations with term-debt ratings (the familiar AAA-style letter ratings).

But within the investment-grade spectrum, there are 10 term-debt ratings, and just 2 for commercial paper. That means that a minor change in term-debt ratings can cause a precipitous drop—a credit cliff, says Van Orman—in a company’s short-term creditworthiness. When a company is lowered to an A-minus rating (which is still well within investment grade), its CP rating drops from Tier-1 to Tier-2. The relative impact on the cost and availability of short-term debt, he explains, is far greater than it is on long-term debt. “And that’s absurd,” he says, “since you would think credit risk is greater at five years than at 30 days.”

Exacerbating the availability problem is a rule that restricts money-market funds—the primary investors in commercial paper—from investing more than 5 percent of their assets in lower-rated Tier-2 CP. At the end of July, some $1.17 billion in Tier-1 CP was outstanding, while Tier-2 outstandings totaled just $69 million.

Moody’s Investors Service president Ray McDaniel says recently introduced liquidity ratings assessments attempt to address the issue “without tearing down and reconstructing the entire short-term ratings system, which would be disruptive to the market.” And since the problem is most severe for a few large CP-issuers like GMAC and Ford Motor Credit, it has failed to garner much attention in the current rating-reform efforts. But, argues Van Orman, given the importance of money markets, and with some $1.3 trillion in commercial paper outstanding today, this is an inefficiency that rating agencies should address. “I honestly believe this is one of the major oversights in their judgment,” he says. “It has negative consequences for both the financial system and the economy.” Plus, his dog is tired of hearing about it. —T.R.

The First Alarm
After initially rating Enron higher than Moody’s or S&P did, Egan-Jones dropped its rating further and faster (ratings in red are below investment grade). Dates indicate a rating change by one or more agencies.
Date Events Egan-Jones S&P Moody’s
03/16/01 A- BBB Baa1
04/19/01 BBB BBB Baa1
06/27/01 BBB BBB Baa1
08/15/01 CEO Jeff Skilling resigns unexpectedly. BBB/BBB- BBB Baa1
10/16/01 Enron announces $1 billion income write-down, $1.2 billion reduction to shareholder equity. BBB/BBB- BBB Baa1 (neg)
10/23/01 BBB- BBB Baa1 (neg)
10/24/01 BBB-/BB BBB Baa1 (neg)
10/26/01 BB BBB (neg) Baa1 (neg)
10/29/01 BB /BB BBB (neg) Baa2 (neg)
11/01/01 One day after Enron announces a formal SEC investigation of partnerships led by CFO Andrew Fastow. BB BBB (neg) Baa2 (neg)
11/07/01 BB-/BB- BBB (neg) Baa2 (neg)
11/09/01 Moody’s and S&P downgrade Enron after major restatement. Egan-Jones briefly upgrades it. BB BBB- (neg) Baa3 (neg)
11/21/01 BB/BB- BBB- (neg) Baa3 (neg)
11/26/01 BB-/B BBB- (neg) Baa3 (neg)
11/28/01 Dynergy revises terms of proposed Enron merger; banks refuse to provide additional cash. C/D B- B2 (neg)
11/29/01 D B- B2 (neg)
11/30/01 D CC (neg) B2 (neg)
12/03/01 Moody’s and S&P rate Enron a default one day after the company files for bankruptcy. D D Ca
Source: Egan-Jones, S&P, Moody’s, U.S. Senate