In the months leading to the collapse of WorldCom Inc., its shares were in a nose-dive, traders were selling its bonds at junk levels and its chief executive was forced out. But not until investors lost several billion dollars did Congress and others begin to rivet attention to a little-known player in this unfolding drama: the credit raters.
WorldCom rose to prominence through voracious acquisitions, including the bold 1998 purchase of MCI, the District-based long-distance telephone company. And it couldn't have done it without the rating companies. WorldCom borrowed money through the sale of bonds, which the rating firms approved by giving them good grades, a signal that they were relatively safe investments.
As it turned out, nothing could have been further from the truth. But the rating firms were among the last to recognize it. It wasn't until weeks before WorldCom disclosed massive fraud and filed the biggest bankruptcy in U.S. history in 2002 that the credit raters finally cut the firm's debt to junk status.
The rating companies say they are not in the business of detecting fraud; rather, they say they give an opinion of the creditworthiness of a company, municipality or nation. But some critics say the WorldCom case highlights a broader problem: that the world's big three credit raters — Moody's Investors Service, Standard & Poor's and Fitch Ratings — have become some of the most important gatekeepers in capitalism without the commensurate oversight or accountability.
From their Manhattan offices, they can, with the stroke of a pen, effectively add or subtract millions from a company's bottom line, rattle a city budget, shock the stock and bond markets and reroute international investment. Without their ratings, in many cases, factories can't expand, schools can't get built, highways can't be paved. Yet there is no formal structure for overseeing the credit raters, no one designated to take complaints about them, and no regulations about employee qualifications.
The big three ostensibly function as a disinterested priesthood. When a company, town or entire nation wants to borrow money by selling bonds, the market almost always requires that the rating companies bless the move by running a kind of credit check. Bonds they deem safe get a good rating. The higher the rating, the lower the interest rate the borrower must pay.
But at the heart of the increasingly profitable business is a conflict: The rating companies get the bulk of their revenue from the fees they charge to the very entities they are rating. Industry insiders say the desire of a rater to hold on to a paying client — or recruit a new one — at times has interfered with the objectivity of a rating.
Dozens of current and former rating officials, financial advisers and Wall Street traders and investors interviewed by The Washington Post say the rating system has proved vulnerable to subjective judgment, manipulation and pressure from borrowers. They say the big three are so dominant they can keep their rating processes secret, force clients to pay higher fees and fend off complaints about their mistakes.
Many of those interviewed declined to criticize the credit raters publicly, saying they did not want to anger those who hold so much sway over their financial fortunes.
Those who disagree with a rating have little recourse. Lawsuits generally have been unsuccessful because courts have upheld the rating companies' argument that they are publishers of opinions, like newspapers, and that their views are protected by the First Amendment.
With little public debate about the industry, the rating business has eluded a series of reforms that have been imposed on other parts of the U.S. financial system. For example, while hundreds of companies and institutions, such as the New York Stock Exchange, have eliminated potential conflicts on their boards, Moody's directors continue to serve on the boards of companies that also are Moody's clients. (Moody's officials say that their directors play no role in ratings decisions.)
And even as accounting firms have curtailed offering consulting services to their clients to avoid conflicts, some credit raters have begun to sell their own consulting services, raising concerns that clients may feel pressured to buy them.
For their part, the credit raters say they ably manage potential conflicts. They say they adhere to strict codes of conduct, such as prohibiting any link between the pay and bonuses of their rating analysts and the fees that come in from the companies those analysts rate. The rating companies also say they perform a public service by allowing investors to compare the relative risk of buying bonds from almost any seller.
And the credit raters say their success over time shows the ratings process works, and that their ratings bring stability to the markets, giving companies and countries access to capital. "Our ratings are essentially a public good," said Frances G. Laserson, a Moody's spokeswoman.
Laserson also said that The Post was raising questions about a small number of cases among thousands of Moody's ratings.
The rating companies say they do their job without regard to the impact, basing their ratings largely on statistical calculations of a borrower's likelihood of default. Subjective factors sometimes come into play, rating officials say, given that there are some two dozen categories ranging from the best, "AAA," to a low of "C" or "D."
That subjectivity can be costly. For a borrower, the difference of a single rating notch could mean millions of extra dollars in interest payments.
Few question the need for a credit-rating system, but many argue that the big rating firms have become too powerful and insulated. In the past decade, the industry has been scrutinized by regulators and policymakers, but no action has been taken to strengthen oversight.
"Here we have a huge issue that has a significant impact on the U.S. economy and the global economy, and nobody seems to be paying attention," said James A. Kaitz, chief executive of the Association for Financial Professionals, which represents more than 14,000 U.S. corporate finance officials.
The association and its counterparts in Britain and France issued a statement in April saying investors have lost confidence in the credibility and accuracy of the big three's ratings and called for a new global code of conduct.
Last year, the Investment Company Institute, whose members include more than 8,000 mutual funds and other investment firms, recommended to regulators that the major rating companies disclose conflict-of-interest policies.
The rating companies officially fall under the purview of the Securities and Exchange Commission. But even as the SEC has clamped down on accountants, stock analysts and investment bankers, the regulator has not imposed rules on the rating companies. The SEC, which declined to comment for this article, said it continues to study the issue.
The SEC made one regulatory move that enhanced the credit raters' power. In the mid-1970s, after the raters failed to anticipate a major railroad default, investors grew nervous about the debt markets. The SEC decided to require that brokerage firms maintain a certain amount of cash, bonds and other assets. How much depended in part on the quality of those bonds.
Regulators weren't sure how to assess those bonds. So the SEC created a category of credit raters called Nationally Recognized Statistical Rating Organizations, or NRSROs. The SEC initially recognized Moody's, S&P and Fitch.
Investors have come to consider the designation as the U.S. government's stamp of approval, and it is used by institutions, such as mutual funds, as a main criteria for investing only in bonds approved by such rating companies. That has helped the big three secure their monopoly, their critics say.
Last year, the government added to its list a fourth company, Dominion Bond Rating Service Ltd., a small Canadian firm. Competing rating companies have complained about their failure to achieve the designation because there are no laws or regulations explaining how to qualify.
Despite their complaints, the industry has received little public attention largely because its workings are complex and its clients are institutions rather than people. (The creditworthiness of consumers is rated by a different set of companies, which operate under extensive federal and state regulation.) But after the collapse of such companies as WorldCom and Enron Corp., Congress ordered the SEC to consider whether new rules were needed. During a 2002 hearing, Annette L. Nazareth, the SEC's market regulation director, wrestled with that question, saying the industry lacks transparency. The debt markets, she said, are "the dark corner" of the securities industry.
A private language
The big three credit-rating firms wield power through letter grades they hand out. They explain their ratings approach in pamphlets and on their Web sites. But the process itself has remained a mystery of finance.
Committees of rating analysts, headed by one lead analyst, meet privately to weigh the financial strengths and weaknesses of those who want to sell bonds. Then, they emerge to give the bond a rating, announcing it to the world. The companies don't say who voted or how the vote broke down.
Over the decades, the rating companies and their supporters say, the system has proved its value and integrity.
"S&P has, in fact, been very successful in flagging deterioration in credit of companies, and that is why our opinions continue to be highly valued information to investors," said Vickie A. Tillman, executive vice president of the company's credit market services. S&P cited several examples of ratings that anticipated problems, at such companies as US Airways Group Inc., AT&T Corp. and France Telecom SA. Moody's also furnished examples, including its work on Air Canada and Conseco Inc.
The rating companies say they get their ratings right most of the time, pointing to their own studies showing that the higher the rating, the lower the rate of default. Out of 98 defaults in 2003, S&P said, only three were companies that had in the past 12 months held investment-grade ratings, which are considered relatively safe for investors. Still, since only a tiny fraction of all bond issuers ever default, the odds of being right are very high, some critics point out.
Tillman said that because it takes a majority of the committee to approve a rating, no one person can skew the process. Those familiar with the process, however, say the committee usually follows the lead analyst because the others often don't have the time to review the work as closely.
The lead analyst's recommendation is "the basis on which everything is turning" and is upheld about 80 percent of the time, said Hans van den Houten, a former Fitch and Moody's executive who also served as a outside recruiter for S&P until earlier this year.
That can sometimes tempt the lead analyst to let personal feelings influence the review of a client's finances. This happened to a former Moody's analyst rating a company at which one executive was a close friend from a previous job.
"I bent over backward to come up with the best result because I care for this person," said the analyst, who spoke on the condition that neither he nor the company he was rating be identified. Later, after the company's performance sagged, the analyst came to see that he had rated it too high.
If an analyst's feelings go the other way, it can cost a company money. Computer Associates International Inc., which has had recent run-ins with U.S. authorities about its accounting, earned a tough reputation for the way it deals with rating analysts. "They were definitely aggressive and abrasive and engendered a combative response from the rating agency," a former rating analyst said.
Performance or personality?
Computer Associates, which declined to comment, held a rating last year barely at investment -grade. Based on financials alone, it would likely have been higher, but its combative executives alienated some analysts. The company's rating ended up lower than expected, costing it potentially millions in extra interest payments. "Maybe a full notch is [due to] their personality," the former analyst said.
Analysts say it's reasonable to use their judgment to assess how well a company's executives make business decisions. But reservations about management will not necessarily show up in the rating firm's public report.
"You don't want to say you don't like these guys," said another former rating official. "You have nothing to point to, but it was discussed in the committee."
Moody's president, Raymond W. McDaniel Jr., declined to discuss specific cases. "The ratings process is produced by human beings, and human beings have views and emotions about certain things," he said, adding that Moody's tracks the quality of its ratings.
"We do not deny there are latent or inherent conflicts of interest in our business," McDaniel said. "The important thing is, how do we manage those conflicts?"
Credit raters say that other industries, including newspapers, have to cope with similar conflicts. "Our practice is no different from The Washington Post who will run ads from Ford, AT&T, Merrill Lynch or dozens of other companies while at the same time reporting on them every day," Fitch said in a written response to questions.
Some rating companies cited a 2003 study by two economists who work for the Federal Reserve who found "no evidence" that ratings are affected by conflicts of interest, but rather that credit raters "appear to be relatively responsive to reputation concerns and so protect the interests of investors."
At the water cooler
Because the major rating companies juggle tens of thousands of debt issues at any given time, many are given cursory attention, according to current and former rating analysts and those they rate. An analyst will cover as many as 55 borrowers at once. And in recent years, the credit raters say analyzing debt has become more complicated, involving more financial provisions.
"You can't monitor all those companies," one former rating analyst said.
So why don't raters hire more analysts? "It would cut into their profitability," he said.
The credit raters say they have a sufficient number of analysts to cover companies throughout the world. Still, at Moody's at least, according to some current officials and former analysts, committee meetings on occasion are hastily arranged, include only two analysts and last minutes, or seconds.
"We had a colloquial term for that," said W. Bruce Jones, a former Moody's official who works for a small competitor, Egan-Jones Ratings Co. "We called it a 'water cooler rating.' "
One meeting that took only minutes involved Omnicare Inc., a supplier of pharmaceutical services to nursing homes, when it announced plans to acquire competitor NCS HealthCare Inc. in 2002, according to another former Moody's analyst.
As soon as the deal, worth more than $400 million, looked imminent, the analyst said he dropped into a supervisor's office and quickly explained that he assumed Omnicare would sell bonds to make the acquisition. As a result, he was going to put its rating on review for a potential downgrade.
He didn't need to explain why: By carrying more debt, the company would become a bigger credit risk. The supervisor promptly gave the analyst approval to proceed.
That was the committee meeting.
Within about a half-hour, the decision flashed to some 5,000 news services around the globe. About six months later, however, Moody's took Omnicare's credit off review. The company planned to use stock, not just loans, to buy its competitor. That meant Omnicare's debt wouldn't be as large as the Moody's analyst had anticipated.
McDaniel of Moody's said his company works diligently to provide well-researched ratings. "We treat the ratings committee process very seriously," he said, but added, "We don't want to waste people's time."
The rating companies said they already have strong internal controls designed to minimize mistakes or conflicts, including codes of conduct at S&P and Moody's.
Moody's, for instance, instructs employees to do nothing that "might, or might appear to, compromise the integrity" of the rating process. The credit raters say they also conduct ethics training in-house.
Still, some lawmakers — Republicans and Democrats — say the system is flawed. In a House hearing last year, Rep. Paul E. Kanjorski (D-Pa.) said the credit raters' failure to identify problems at WorldCom and other major companies "ultimately resulted in the loss of billions of dollars for American investors who little understood the true credit risks."
Staff researcher Richard Drezen contributed to this report.