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Standard & Poor's: silent but deadly

A look inside the inscrutable and confidential world of the ratings agencies

Outside the nondescript Madrid offices of what is becoming one of the most feared agencies in Europe, and perhaps in the Western world, a young 30-something casually lounges against a wall smoking a cigarette. Speaking Spanish with a foreign accent, the man reveals that he is in fact an analyst, one of 'those' who over the last few months have managed to tumble markets across the world with seemingly 'no mercy' sovereign downgrades.

On Saturday, European heads of government were still grappling with Standard & Poor's Friday downgrade of nine European nations, a move it had been warning of since early December. Spain saw its ratings fall two notches to A, which left only four euro-zone countries with the agency's top AAA rating: Germany, the Netherlands, Finland and Luxembourg.

Stubbing out his cigarette, and giving only the briefest, noncommittal answers (in English), the analyst joins a group of his colleagues, all more or less the same age. They are forced to develop a thick skin, these young professionals, due to the criticisms that arise with each new downgrade. But their code of conduct doesn't especially endear them to the public either. They don't speak of their work and they don't make public declarations; in short, they are invisible. Under increasing scrutiny lately, however, they have been more willing to offer up some defense.

Myriam Fernández de Heredia, the only Spaniard with a position in S&P's upper echelons as head of sovereign ratings for Europe, the Middle East and Africa, and who most likely had a voice in Friday's decision, says, "We don't like for people to comment when they don't know what they are talking about. We follow a prescribed methodology. We don't just act on a whim."

And how do they work, exactly? The world's three main ratings agencies - S&P, Moody's and Fitch - dominate 95 percent of the global ratings industry, and use a similar "communicating vessels" method, which creates teams that are much more "integrated and cohesive," says Heredia. "They are not working in silos."

Work is divided into four departments: sovereign markets and the public sector; banking and insurance; private companies and structured financing. In sovereign credit ratings, assessment is based on five factors: political, economic, external liquidity, fiscal and monetary. Each segment is given a point grading between one and six, the highest mark. The final rating, which ranges from AAA to junk bond, is based on this scoring.

Ratings are performed on behalf of a client, and assess the potential to meet debt payment. In the case of country ratings, it is the government that asks for the agency's services - generally. Some sovereign ratings are not requested but are performed at the agency's initiative for investors. In addition, the agency's methodology calls for a country rating in order to assess companies within that country. The operating method is routine. Two analysts propose a rating to a committee of senior analysts. They communicate by video conference or telephone. The committee is always comprised of an uneven number of people, normally five or seven. Their names are not disclosed.

The committee's final decision is given to the client and, in accordance with European regulations, remains confidential for 12 hours. Once a rating is given, continual follow-up is performed and at least one revision is carried out per year. Revisions are increased during times of instability, such as we are seeing now. This is what occurred last Friday.

"A rating is always alive," says Heredia.

Inside the ratings agencies, a strict code of regulations and confidentiality governs. Employees are not allowed to accept gifts, discuss fees, or make unilateral decisions. The agencies are, of course, for-profit entities that are publicly listed (in the case of S&P, its mother company McGraw Hill is listed). Although Warren Buffet owns 10 percent of Moody's, in general the agencies' capital is shared between a number of investment funds, many of whom the agencies have in common. This, combined with the agencies' virtual oligopoly, clearly links their moves.