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Ranting At The Ratings Agencies


Sean J. Egan is a squeaky wheel. His Egan-Jones Ratings Co. has fewer than a dozen credit analysts, a modest Philadelphia-area office, and about 400 subscribers. He's dwarfed by the giants of the credit-rating business, Moody's Investors Service (MCO) and Standard & Poor's (like BusinessWeek, part of The McGraw-Hill Companies (MHP)), each with more than 1,000 analysts. Yet, Egan has made an outsize name for himself in part by loudly bashing the big firms.

For nearly four years, Egan has fed off the corporate scandals of the early 2000s and the giants' failure to predict the collapses of Enron Corp. and WorldCom Inc. (MCIP) -- and stoked the criticism of Moody's and S&P on Capitol Hill. At five government hearings he has slammed his big rivals as monopolists, flawed by a "significant conflict of interest" because they collect fees from the borrowers they rate. Egan, who takes money only from investors, downgraded Enron and WorldCom debt to junk 1 month and 10 months, respectively, ahead of both Moody's and S&P. This year, he berated "Tweedle Dum and Tweedle Dee," as he calls them, for being slow to downgrade borrowers, such as American International Group Inc. (AIG) and Delphi Corp. (DPH), that faced accounting scandals. "We have changed the dialogue," says Egan, 48.

KEEPING HIS SECRETS

Egan's campaign is hardly disinterested. Since 1998, he has tried unsuccessfully to persuade the Securities & Exchange Commission to designate his firm a "nationally recognized statistical rating organization." Apart from prestige, such status gives an agency's ratings legal standing in determining whether financial players are complying with regulations, debt covenants, or investment policies. With a Harvard MBA and experience in structured finance in the 1980s, Egan actually started his firm 13 years ago as Red Flag Research. He's been issuing ratings since 1995. The SEC has never said why it is withholding the NRSRO designation.

Unlike his big rivals, Egan doesn't disclose much about how he rates borrowers. In fact, Egan reveals little about his operations. He declined to be interviewed in his offices, saying they're not set up to receive visitors, instead meeting twice with BusinessWeek reporters at Philadelphia's main train station. Egan won't say who his analysts are, where they work, or exactly how many companies they rate. If he provided the information, he says, Moody's and S&P might hire his analysts away, which could disrupt his firm.

"EARLY WARNING SYSTEM"

What matters, Egan maintains, is that his ratings are "timely and accurate." Indeed, some subscribers use them to anticipate actions by Moody's and S&P. That's because changes in ratings by the big agencies often lead to large swings -- and profit potential -- in bond prices. A. Alexander Porter Jr., partner at money manager Porter Orlin Inc., says he uses Egan-Jones as a "distant early warning system" for changes by the big agencies.

If Egan-Jones is as good as Egan claims, such users should be making loads of money. Egan's Web site lists a seemingly stunning record of "hits and misses." He registers a hit when one of his ratings changes is later followed by one of the big agencies and a miss if the change is in the opposite direction. For 2004, he claims an impressive 355 hits, vs. just 14 misses. However, if he predicts a change and neither Moody's or S&P acts, he doesn't count it in the score, Egan confirmed. In that case, his tallies would not include a miss for the 21 months in which Egan rated Pfizer Inc. (PFE) AA, then lowered it to AA-, only to raise it again to AA, all while S&P held steady at AAA. Such omissions could happen a lot: Egan-Jones changes its ratings twice as often as Moody's, according to a study by professors at the University of Michigan and Stanford University. Egan admits "there are some flaws in measurement" but says his clients are sophisticated enough to know what they are.

Whether because of their infamous misses or Egan's critiques, Moody's and S&P now give more advance warnings when they see companies slipping toward a downgrade. They do more to detect accounting shenanigans earlier. They monitor stock, bond, and options trading -- the heart of Egan's approach -- for clues about a company's health. "The bigger agencies have gotten quicker," says Patrick Fry of Associated Investment Management in Green Bay, Wis., an Egan-Jones subscriber.

Moody's and S&P won't give Egan any credit for the improvements they've made. "Our ratings process constantly evolves in response to marketplace needs," S&P said in a written statement. Spokeswoman Frances G. Laserson says Moody's acted as a result of its own assessments after Enron and after listening to government officials, borrowers, and investors. The agency, she says, is cautious about changing ratings because investors want them to be less volatile than market opinions. She adds that Moody's manages potential conflicts of interest by strictly separating credit analysts from salespeople. S&P has similar controls and says studies show that the agencies successfully manage such conflicts.

Despite the changes, says Edward I. Altman, a finance professor at New York University's Stern School of Business, "the big agencies will always be slower." Investment professionals like it that way because herky-jerky ratings changes would force them to churn their portfolios. It's unlikely Sean Egan is going to change that.

By Jessi Hempel and David Henry in New York


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