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The Great Debate

Why does anyone take S&P seriously?

By Roger Martin
August 9, 2011

By Roger Martin
The opinions expressed are his own.

It drives me nuts that anybody treats the Standard & Poor’s downgrading of the U.S. government’s credit rating with anything but contempt.  I am, by the way, not saying that the circus in Washington didn’t deserve an immediate smack-down before the real one it will be getting in 15 months.  But it stuns me that people don’t ask themselves just what S&P is and who its credit raters are before actually paying one iota of attention to them.

So who are those S&P raters anyway – the people who actually determine whether the U.S. is AAA or AA+? The only thing that can be known about them is that if they are rating bonds at S&P, they can’t possibly be good at rating bonds.  The bond market is a multi-trillion market that is immensely lucrative.  Bond trading is a great way to make a buck because there are unlimited bucks to be made – if, and only if, you know something useful about whether the bond in question actually has a lower or higher risk inherent in it than level implied in the market’s current pricing.

So if you are any good at all at rating the riskiness of debt instruments, you will not be working for a couple hundred thousand a year at S&P, you will be working for yourself, or for the bond trading desk of an investment bank or a bond hedge fund making tens of millions of dollars per year – or a lot more if you are running the hedge fund.  Only if you are incapable of knowing something useful about the true risk profile of bonds will you take a job rating bonds at S&P. Or alternatively you actually know something useful but have no confidence whatsoever that you know do so you won’t put any personal financial risk behind your opinions.  In either case, the output is clear: because of the position you occupy, you are someone to whom no one should listen.

Some may argue that no, these people are public servants, like teachers or judges, who rate bonds business they think it is a higher calling and even though they could earn tens to thousands more trading bonds than rating them, they stick it out because of their great hearts.

That is a pretty difficult argument to make. S&P is a subsidiary of publicly-traded corporation McGraw-Hill.  S&P is driven to help McGraw-Hill march its quarterly earnings ever forward lest bad things happen to both subsidiary and parent.  This is hardly the environment in which we are likely to find a huge agglomeration of public servants.

And remember the business model of S&P: it makes its money from charging those it rates lots of money to rate them.  Prior to the crash of 2008, it was an awesome business because the use of its product was legislatively driven.  That is to say, most institutional investors have regulatory fiduciary requirements that necessitate the use of credit ratings as part of their daily business.  They may think that S&P really has no useful insights, but they still need to use its ratings.  So this business is pretty much like any business that is given a legislative right to serve – like your local electric or gas utility: it doesn’t need to worry much about being any good because the customer doesn’t have much choice.

This is all theoretical, you might argue.  OK then, let’s go empirical.  What is S&P’s recent track record on understanding and rating debt instruments in the USA?  Answer: disastrously bad.  Three years ago it could not have possibly been more wrong on its ratings of U.S. mortgage debt instruments.  Chimps throwing darts would have been infinitely better than these so-called experts were.

So the question has to be asked again:  Why on earth do we pay any attention whatsoever to S&P’s downgrade of U.S. government debt?  It has a horrible track record and in fact helped enormously to get the U.S. government into the crisis for which it now condemns the handling.  Their raters wouldn’t be rating bonds if they actually were any good at it.  It operates in a protected industry that insulates it from the usual consequences of incompetence.  And its business model is one big conflict of interest.

Comments
64 comments so far | RSS Comments RSS

I’m wondering if those who comprehend risk rely on the S&P “ratings” to make bets against things like mortgages, etc. Seems to me that S&P serves them quite well – they fully understand there is a lot of money to be made between what they know and what the rating agencies tell you and me. Too bad they aren’t taxed adequately for their gains.

Posted by CatOp | Report as abusive
 

This rant is really derogatory towards employees of S&P and shows a lack of knowledge of the basic underpinnings of how efficient capital markets work. These rating agencies are essential for informing investors who are in turn better equipped to make their own assumptions about the price of an asset. These agencies simply run models based on multiple factors (integrative models if you will) to come up with a rating. To assume that if you are “any good at all at rating the riskiness of debt” you would be out on your own making tens of millions shows complete ignorance towards the world of finance and business at large. This is a dean of a business school? I guess I’d say if you were any good at understanding how business works you’d be making tens of millions or more running a business instead of teaching MBA students. (Or is that a horrible argument?)

Posted by Rotman10 | Report as abusive
 

Roger Martin:

Congratulations! In your attempt to garner publicity for yourself and the Rotman School of Business and slam S&P, you have actually discredited yourself. While S&P has no doubt made mistakes in the past, by arguing they are sub standard analyst because they don’t make millions of dollars or work at a hedge fund is a poor argument to make. Furthermore, they were not the only ones that were the cause of the financial crisis. Is this the kind of rationale or train of thought you and your professors teach at Rotman now? If you are so smart and are such a great leader, perhaps you shouldn’t be hiding at U of T and should get a real job as a CEO of a major corporation making tens of millions of dollars yourself. The last time I checked the Public Sector Salary Disclosure list (http://www.fin.gov.on.ca/en/publication s/salarydisclosure/2010/univer10b.html), you only made $388,335. Even with your side businesses, this is not even close to what a “real” leader in the corporate market place would make.

Posted by Anonymous | Report as abusive
 

@ Strader “hmmmmm… For all those people who agree with roger martin. For argument purposes, please explain to me why the US deserves AAA credit rating.”

Because as sad as the global financial situation is, the US is still probably the safest bet. We haven’t raised taxes to levels in other countries yet, which we could if it really came down to it. And we haven’t cut all the spending. Again, which we could if we really wanted to. People wouldn’t be happy, but an unhappy poor American is a hell of a lot richer than most people in this world. Don’t come after me, I’m speaking in an average sense. I know that there is a lot of money in Europe and a lot of money is being made in China but all in all, the average US citizen is pretty well off and educated.

In addition, we still are the reserve currency and will be for the time being. You can’t look to China, unless they were completely honest with their financial situation, but for all we know it could be smoke and mirrors. They keep their currency pegged to us by buying treasuries, and keep their currency low, so who else is there you can trust? The debt ceiling debacle, because they waited till the day of to pass it, probably pushed it over the edge. If they would have just passed it like it has been numerous times with no BS like they pulled this time, we probably wouldn’t have been downgraded. Yes there are long term problems that need to be addressed, but we also need to get this country growing economically again.

I think the markets already understand this and have for a long time, otherwise there would have been a flight from treasuries before they were downgraded and certainly afterward. However, it’s the complete opposite. They know they will be paid and they know that we will eventually turn it back around.

Posted by DamianPalmares | Report as abusive
 

Seems like an ample supply of hubris is available, both at S&P and Reuters.

Posted by ARJTurgot2 | Report as abusive
 

Your article shows little insight for a Canadian. Do you remember how your homeland handled its poor rating a few years ago? Don’t you agree that the USA has a rising debt
burden and with Obama the debt is going to get worse because of his plans to tax middle class, etc.? I would like your reaction to Stephen Harpers comments about the new US AA rating as well.
Thanks for your opinion on this issue but you should not short change it just because you don’t like the messenger….

Posted by RichardMac | Report as abusive
 

Sure, when it is time to downgrade Spain then S&P is a valuable tool.

But when it is time to downgrade the US it is a questionable and basically worthless thing.

It is exactly this kind of attitude which ultimately led to that very same downgrade.

Posted by galonga | Report as abusive
 

So the banks are at it again. Who is shocked? What is it that an accountant does? Watch the bottom line at all costs.
When your accountant says you are spending more than you earn-do you
a) Stop spending
b) Get another job
c) Do nothing
d) Get another accountant
Call it an oversimplification but maybe that is what is needed in this global economic mess.

Posted by ex-fungi | Report as abusive
 

Dean Martin,

This is a great blog and very well articulated. I must say though, the acrimonious tone of this blog is vastly different from what we are used to; however, I suppose the attitude shown is consistent with that shown in your enlightening book “Fixing the Game”. That being said, I do think your points are valid, but they certainly could have been articulated with less antagonism, while maintaining the key elements of your opinion.

A couple of thoughts:
1) @ Rotman 10: How can you stand by your comment that rating agencies “are essential for informing investors”. I think it behooves a prudent investor to critical assess past performance of the rating agency before relying on the information they provide. We all know they were behind the proverbial eight ball in 2008 in their over-zelous ratings

The (in)famous Hedge Fund Manager Bill Ackman even said in the documentary “Inside Job”, that ” Moody’s and S&P get compensated based on putting out ratings
reports. And the more structured securities they gave a AAA rating to, the higher their earnings were gonna be for the quarter”. In fact, Moody’s “quadrupled its profits from 200-2007″, primarily around rating more structure securities AAA. Even
Jerome Fons, past Managing Director of Moody’s has stated that “the rating agencies could have stopped the party, and said: We’re sorry – you know – we’re gonna tighten our standards. This is – a-, and, and immediately cut off a lot of the flow of funding to risky borrowers”.

How can you call a rating agency credible when they are driven by ulterior motives. From 2002-2007, AAA rated securities exploded. When placed in front of Congress in 2008, Deven Sharma, Stephen Joynt and Raymond McDaniel’s have clearly expressed that the ratings are only their opinions, and that they shouldn’t be relied on. What about during the tech bubble? Infospace, Excite, and other eventual failures were given AAA ratings. How can you really place confidence and call them credible when they are driven by ulterior motives? And the rating agencies certainly cannot be associated with discussions around market efficiency…. sorry

2) @Anonymous who believes being a dean of a leading business school in Canada and ranked as one of the top finance MBA programs globally (source: In the 2008 Financial Times rankings of MBA programs, Rotman ranked 1st in Canada, 20th in North America, and 40th in the world. In the “Best in Finance” category, Rotman placed in the top 10 worldwide (6th) alongside NYU Stern, Chicago GSB, MIT Sloan, Harvard GSB and Wharton) is not credible enough, then is it not sufficient that:

1) In 2009, Roger Martin was named one of the top 50 management thinkers in the world by The Times of London.

2) In 2007 he was named a Business Week ‘B-School All-Star’ for being one of the 10 most influential business professors in the world.

3) He serves on the Boards of Thomson Reuters Corporation and Research in Motion and is chair of Tennis Canada

4) Oh btw @Rotman10, wasn’t Roger Martin director and co-head of Monitor Group and founded the Canadian office before he became Dean?

I think he has proven himself credible enough.

Anyways, I’m not here to defend Dean Martin, I’m simply showing that your arguments are bit unfounded and to an extent, asinine.

Posted by northof60proud | Report as abusive
 

Martin is spot on on his analysis.
If you are an S&P employee and feel slighted, suck it up.(Or get a new job). You work with the corrupt banksters. While I applaud your downgrade of America’s credit rating I also know you are controlled by the banksters who have one goal: bankrupt the world, and go from one country to another picking off cheapened assets starting with Greece.

It won’t happen here in America however, the people will be on the streets soon enough here, everyone is sensing this, even Buffet is going out of his way to request increases in taxes on himself that the paid for Congress schiesters refuse to allow do(Buffet is not the only billionaire in the group, how about the billion dollar corporations paying little to no taxes in the US?). While Buffet’s motive is self serving i.e. self preservation(he knows what is coming), I applaud him for his honesty and integrity. Unfortunately the banksters who are the true masters of Congress will try to ram cuts and tax increases on the middle class instead. Then you will see people on the street. And hopefully it will be non violent with the targets: the RICH bankers corporations and others who have fleeced the USA.

At any rate, the author is right, S&P is irrelevant, our currency is still the world’s currency, and won’t be affected by this move at least in the short run, long term, we are still going to fail economically as a country, Bernake is running out of tricks, and if and when hyperinflation sets in, the self fulfilling prophecy that we all see forming but hope never happens, WILL happen. Of course the banksters are paid and will swoop in to try to “rescue” us. HAHAHA. You couldn’t have written a better script for the demise of our country!

If you posters that love S&P want to minimize their role in the bankster heist, go ahead, but you making excuses for S&P is like the witness who was kidnapped and saw her loved ones destroyed by S&P now saying that we should believe S&P because they have now “reformed” themselves.
Sorry S&P you have not earned that trust as yet, and you never will. You played a large part in why trillions of dollars are now lost for good because you gave AAA ratings to Wall Street’s riskiest assets and now you want us to believe anything you or your employees say?
My answer to that question is the same answer General Anthony McAuliffe gave to the Nazis when they asked for the 101st surrender during the battle of the Bulge: NUTS!!!

Posted by Independent007 | Report as abusive
 

pass the NUTS. I’m not MBA material or dean of anything. But on main street, people are talking revolution. It’s never good to try and profit from common folks misery. They not only own guns. They use them. Stirring them up by profiteering on oil market fluctuations, AAA ratings, Chinese manufacturing or any of the multitude of shenanigans you rich power brokers pull-just begs the question. Do you really think we’re going to take it much longer? Someone…someone you may know or we all may know, is going to pay. Obama was right about us hicks clinging to our guns and religion. We aim straight and ask forgiveness later. The latest feel good proposal is drug-testing welfare recipients. That’s gonna cost 30 times the savings, but it feels good to hard working…I mean laid-off middle class. S&P are liars deserving of tar and feathers. My R&D anticipates market upswings in both.

Posted by pHenry | Report as abusive
 

@northof60proud – that’s wonderful dribble regurgitated from left wing nut authors. The fact of the matter is that very little information out there is completely unbiased. It is the abundance of information available for an investor to make informed decisions based on their analysis of that information that adds to the efficiency of the capital markets.

Next you’re going to tell me that equity research does not support the efficiency of the capital markets becuase price targets are almost never accurate, and the analysts are unbiased because investment banks earn revenue from the companies they cover.

Hate to break it to you but the world ain’t perfect outside of academia. There is very little black and white outside of those textbooks.

Posted by Rotman10 | Report as abusive
 

If S&P could rate the edo’s for years as aaa as only there opinion. then there opinion should be rated as junk bonds

Posted by lwp | Report as abusive
 

S&P is once again exerting its influence on world affairs and governments. If S&P were but another business one might interpret their announcements as simple opinion. However, in very real terms, S&P “opinion” affects the social and political direction of entire nations to the extent that the wishes of the citizenry may be rendered irrelevant. So, the real role of S&P (and its ilk) is much more significant than that of a simple purveyor of opinion. Their pronouncements often have profoundly negative impacts on people, flesh and blood people who labour day in and day out without any understanding of the hammer that is hanging over their heads. They are the unwashed, the “human resources”, the future of whom S&P does not consider in its pronouncements. Odd that human resources are valued so much less than capital resources. Please don’t bother with the platitudes about what’s good for capital is good for the people or any of the other associated platitudes. With the rapid decline of the middle class, the rampant growth of homelessness, and the prevalence of the working poor, its hard to imagine what are the successes of capitalism as S&P define it.

Posted by doc_in_bc | Report as abusive
 

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