Standards for the Poor Man

Has Standard and Poor’s learned a lesson and found back to the roots of its trade?

May 30, 2002

Has Standard and Poor's learned a lesson and found back to the roots of its trade?

In 1860, Henry Varnum Poor published “The History of Railroads and Canals of the United States.” The resulting interest led him to build a company that supplied information about U.S. businesses.

In 1941, Poor’s company merged with the Standard Statistics Bureau, a company started in 1906 and which assigned debt ratings to corporate bonds. The two companies, after all, had similar lines of business. And the names were appropriate.

What exactly does Standard and Poor’s do? It takes the role of judge and jury when a corporation issues bonds.

By taking apart the issuing company’s balance sheet, and researching its underlying business prospects, Standard and Poor’s determines the relative safety of investing in the company’s bonds — how likely, one might say, the company is to repay a bondholder’s money.

Then, the rating company assigns a letter grade which allows investors to compare the relative safety of bonds issued by very different companies. The best companies get ‘AAA’ ratings (and pay relatively low interest rates).

If the rating company decides that the company’s propects are risker, it might issue the dreaded ‘B’ or ‘CCC’ ratings. Such risky bonds are called “junk” on Wall Street. And companies that issue them are required to pay higher interest rates. (See rating definitions)

This standardization is a key element in the creation of broad financial markets. It gives everybody — sellers, investors and reporters — a common and easy to understand way to compare the potential risk and return of different bonds. Hence, the Standard part of the name is very appropriate.

And Mr. Poor? Well, his name indicates who benefits from such standardization. It is the investor who cannot afford the time and cost of the research necessary to closely examine a large number of companies.

Today, Standard and Poor’s efforts go far beyond just giving marks to bond issuers. Perhaps its best known method of distilling complex market information is the famous Standard and Poor’s 500 stock index.

That index now forms the basis for many of the stock index funds that are a key tool for the retail investor. That helps just about everybody with a retirement account — which, in the United States, means a very large number of households.

But Standard and Poor’s eventually became part of the financial establishment. That was a shame, because the market needs independent analysis.

Investors need to break free of the group-think that all too often takes over Wall Street. Standard and Poor’s was in the perfect position to do so. But it did not.

The resulting outcome was a real failure for the company. It missed out on its true calling during the international financial crises of the 1990s.

It would have been nice if somebody had blown the whistle early — on Mexico in 1994, on Thailand in 1997 and on Russia in 1998. Standard and Poor’s — along with Moody’s, the other major rating agency — however, were silent.

It seems that the company’s analysts got too chummy with the bond salesmen on Wall Street. Investors started to wonder: Just what is the value of a company whose ratings decline after the news comes out that a debtor is in trouble?

More recently, the same thing happened again. Companies like Enron and Global Crossing received quite good ratings — until it was too late. By the time Standard and Poor’s got around to lowering their ratings, everybody already knew about their problems.

That was embarrassing. After all, a rating company’s value lies entirely in its reputation. So not going against the crowd to find the truth was potentially costly for the company.

Fortunately, somebody at Standard and Poor’s seems to have taken notice of the issue. How do we know?

The issue at hand is stock options, which give lucky employees — usually CEO's — the ability to purchase shares of stock at a fixed (low) price some time in the future. Under current rules, grants of such options are not counted as a "cost" on the balance sheet of the granting company, even though it will eventually have to buy or create stock to fill the options — at a cost to the company's other shareholders.

So far an acrimonious debate on this issue has yielded no changes. U.S. corporate balance sheets continue to avoid listing options grants as a cost.

That makes earnings look better than they would. It also leaves investors the possibility of being unpleasantly surprised when employees cash in those grants in a few years.

Rather than enter the debate, Standard and Poor's simply decided — as part of its regular analysis — to subtract the cost of these options grants itself, and provide its subscribers with a newly defined "core" earnings amount that takes options grants into account.

This is a courageous decision that validates the company’s name. It puts Standard and Poor’s on the side of investors and especially of the little guy — and in opposition to the wealthy interests of Wall Street and the corporate CEOs that are fighting tooth and nail to prevent recording options as a cost to the issuing companies.

It’s nice to see an American institution return to its roots — and to the true meaning of its name.