Terry McGraw's Problems At S&P

The Wall Street Journal ran a very revealing article two weekends past on how McGraw-Hill and, in particular, its CEO, Terry McGraw, are dealing with the fallout of S&P's disastrous fumbling of rating CDOs.


The article begins with this passage,


"Last October, a hedge fund manager asked McGraw-Hill Cos. Chairman and CEO Harold McGraw III whether bond ratings downgraded by the company's Standard & Poor's Ratings Services unit amid recent market turmoil should have ever been issued in the first place.


'What we do is provide access to the capital market,' Mr. McGraw responded. 'If the market wants those kinds of products and the institutional investors want those products, then we move with the market and we're going to rate whatever.' "


The Journal piece goes on to state, about McGraw,


"But he helped set the tone at the bond-rating firm, which stressed profit growth and keeping costs relatively low."


Doesn't that just explain it all?


In a companion piece in the same edition of the WSJ, on the same page, one reads,


"At S&P, revenue from rating the mortgage-laden bond portfolios grew more than 800% from 2002 to 2006, but related staffing doubled. At Moody's, the comparison between revenue and staff growth was similar, but its growth rate in CDOs was somewhat lower than at S&P."

The party line from McGraw-Hill about this sensitive issue was, as reported in the article,

"S&P 'has consistently invested in resources and increased its professional staff across its business lines.'"

I think this alone is evidence for anyone with experience in large corporate cultures to understand what happened.

Terry McGraw and his senior staff were determined to collect as much of this 55% per annum revenue growth on the corporate bottom line as possible. Nobody was going to be seeing anywhere near even +25% growth in expense or staffing levels per year.

In the aftermath, of course, it seems short-sighted for McGraw-Hill to have been so stingy. Its reputation, and perhaps even its prized, unique access to the bond rating business, is now severely damaged. But just on the basis of the financials, it's easy to see that the firm made a fatal miscalculation that the quality and content of its ratings work were, in effect, of no actual value. It was the application of 'some' rating to an issue that added the value.

And for that, who needed to maintain internal quality and operational standards?

Another quote from the second article confirms this. An internal email has one S&P staffer writing, regarding an issue,

"we should not be rating it."

The email received a reply contending,

"we rate every deal......it could be structured by cows and we would rate it."

It's evident that the pressure to crank out revenues, earnings and, parenthetically, ratings, was intense at the S&P unit of McGraw-Hill. The Journal piece focusing on the CEO concluded by noting that S&P became the high-growth unit to offset sluggish performance in the less glamorous parts of the publishing giant.

The article contends that Terry McGraw wanted his family firm to becoming a growth equity, and decided that pushing for abnormally-high growth at the ratings unit would deliver on that objective.

As with most high-growth businesses, they don't remain so indefinitely, nor without commensurate costs over time.

One way, or the other.