Standard & Poor's: What it does and why

Henry Varnum Poor wanted to find a stable way to evaluate railroad stocks in the 19th century.
Henry Varnum Poor wanted to find a stable way to evaluate railroad stocks in the 19th century. (A.D. Chandler Papers, Harvard Bus. School)
Posted: August 11, 2011

It's ironic, perhaps, that Henry Varnum Poor, founder of Standard & Poor's, was schooled by the business booms and busts of the 1800s.

Just about as ironic as the fact that S&P, which last week rocked the world's financial markets by lowering the long-term credit rating of the U.S. government, is a symbol to some of all that is wrong with Wall Street.

But first, a little more about Mr. Poor.

He marveled at investors' desire to bet money on railroads with no clue about their financial prospects. So he started recording incomes, debt levels, amount of freight hauled, and other statistics for hundreds of companies - from the Philadelphia, Germantown & Chestnut Hill to the Union Pacific.

His personal obsession grew into one of the world's largest ratings organizations, and, in recent years, a player in just about every major boom and bust.

S&P's downgrade of U.S. debt won it cheers, jeers, and an unlikely place in the spotlight for a firm that keeps much of what it does private.

And it hasn't always looked good in that spotlight: In the housing meltdown, S&P, along with Moody's Investor Services and Fitch Ratings, gave top ratings to the packages of home loans that later went so bad people now call them "toxic assets."

Without the ratings, many of those loans could not have been made. Regulations required the debts to be rated, and, for a time, only Moody's, S&P, and Fitch could legally rate them.

The firms were supposed to be objective arbiters, but lucrative fees turned their heads. Lenders unhappy with a potential rating simply threatened to take their business elsewhere.

"I knew it was wrong at the time," former S&P managing director Richard Gugliada told Bloomberg News. "It was either that or skip the business."

Sen. Carl Levin (D., Mich.), who headed a 2010 investigation of the ratings firms' role in the meltdown, zeroed in on the fees. "It's like one of the parties in court paying the judge's salary," Levin said before hearings on the matter.

This week, in a New York Times column, the economist Paul Krugman called S&P "the last place anyone should turn for judgments about our nation's prospects."

It didn't help that S&P stood by its downgrade of U.S. debt even after Treasury Department officials pointed out that the firm's figures were off by $2 trillion.

So some critics see S&P's decision as a fairly transparent effort to look tough, regain its reputation, and fight attempts at increased regulation.

"There is a lot of 'reputation recovery' going on," said William O'Connor, a partner in the financial services practice at Crowell & Moring.

S&P denies that, says it has curbed conflicts of interest, and notes that outside of the housing arena, its ratings have largely proved accurate.

The firm said its downgrading simply reflected the United States' growing debt levels and political gridlock. "We make the calls on the credit risk as we see it, to the benefit of investors," S&P said Wednesday in a statement.

Vincent Truglia, managing director of global economic research for Granite Springs Asset Management and a former head of the Moody's unit that issued opinions on nations' debts, knows the potential for backlash. He remembers the Italian official who claimed Moody's was part of a global conspiracy to hurt Italy.

In a blog post before Friday's downgrade, Truglia said he, too, worried that political brinkmanship had damaged U.S. reliability. "To maintain an AAA rating, a borrower should possess a sterling credit culture," he wrote. "What we just witnessed over the last several months is far from sterling. It was appalling."

So how does S&P decide to downgrade U.S. long-term credits from AAA to AA-plus?

S&P's basic job is to assess how likely a government is to repay its debt. Analysts pore through a country's finances, typically meeting with government leaders at least once a year and talking regularly by phone.

The company assigns a score from 1 (highest) to 6 for various factors, including a country's political and economic situation. Then, a committee - S&P says it wants to shield the group from outside pressure, so it won't name all the people who decided to downgrade the United States - assigns a final rating and writes a report.

It's dry stuff. Here's a taste: "Each score is based on a series of quantitative factors and qualitative considerations described in subpart VI. c below." (For the economics-major version, read S&P's explanation of its methods here: http://bit.ly/n4oJto)Then, investors use those reports to decide where to put their money.

Bill Roberts, who heads the taxable credit research group for Vanguard, the mutual funds giant in Malvern, said his company uses such reports as just one stone in its research mosaic. "We rely on our own view of credit risk and look at market pricing of debt securities and determine whether we like the issuer or not," he said.

Roberts offered a footnote:

Vanguard still views the United States as AAA.


Contact staff writer Miriam Hill at 215-854-5520, hillmb@phillynews.com, or @miriamhill on Twitter.

 

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