The Backlash Against S&P Begins

The U.S. has launched an investigation of the rating agency, and municipalities are shunning it

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Apparently, it isn't so fun to get downgraded. Earlier this month, Standard and Poor's downgraded the U.S., which caused a domino effect and pushed down the ratings of bonds issued by other entities implicitly guaranteed by the U.S like some municipalities. The retaliation appears to have begun.

This week, we're learning that some of those local governments are dropping the agency from the group it pays to rate its debt. Meanwhile, the U.S. Justice Department is reportedly investigating S&P for its mortgage bond rating mistakes. Yet S&P rejected a proposal that would have changed the ratings market framework in a way that might have prevented bond issuer retaliation. The agency may only have itself to blame for its situation.

The U.S. Investigation

Let's start with the news. It certainly may seem convenient that the U.S. is now investigating S&P for its poorly conceived ratings on mortgage-backed securities during the housing bubble. While there's little doubt that the agency erred in handing out strong ratings to so many weak deals, should we question the U.S.'s motives here? Is it just looking for revenge after the agency downgraded the nation's debt?

Perhaps, but according to the New York Times, the investigation began before S&P downgraded the U.S. -- but how long before? Remember S&P got the rating agency outrage ball rolling back in April. It was the first to question rising political risk in the U.S. as it revised the nation's debt outlook to negative. Moody's and Fitch followed with their own warnings, of course.

Even if this investigation was started before any of this downgraded business began, it is now hopelessly compromised. To the extent that those who have influence in Washington can push the Justice Department to go harder on S&P, they probably will. It's also worth noting that the other rating agencies -- which made just as terrible mistakes as S&P during the housing bubble -- are not known to be targets of similar investigations.

Municipalities Drop S&P

Some municipalities are clearly and directly retaliating against their downgrades stemming from the U.S. rating change. Los Angeles, for example, has dropped S&P from the group of agencies that rate its bonds. So have two other counties, with others considering similar moves. This will mean lost income for S&P, but the agency should have anticipated such potential consequences to its contrarian stance going in.

Lost Credibility With Other Issuers and Investors?

The bigger question for S&P's future prospects is whether or not the U.S. downgrade will have broader, lasting negative effects on its business. Losing fees from a handful of municipalities isn't going to break the firm. But if other issuers worry that S&P is becoming overly conservative in its rating approach, then they might also choose to turn to other agencies instead. We'll have to wait to see.

Investors' reaction has been somewhat mixed. After the U.S. was downgraded, Treasury yields dropped, which means that investors were willing to pay even more money for Treasuries. This is precisely the opposite of what would have occurred if investors had abandoned U.S. bonds due to the risk that S&P's downgrade attempted to highlight. Yet reports indicate that municipal bonds were affected more adversely.

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Daniel Indiviglio was an associate editor at The Atlantic from 2009 through 2011. He is now the Washington, D.C.-based columnist for Reuters Breakingviews. He is also a 2011 Robert Novak Journalism Fellow through the Phillips Foundation. More

Indiviglio has also written for Forbes. Prior to becoming a journalist, he spent several years working as an investment banker and a consultant.

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