Washington and Wall Street Asked for S&P's Downgrade

Should investors and politicians regret criticizing the rating agencies for not being bold and proactive enough up through 2008?

600 geithner point REUTERS Jonathan Ernst.jpg

"Okay Congress: You want us to be more aggressive with our ratings and not just stamp AAA on any old bond? Then how about this -- you're downgraded." This proclamation wasn't a part of Standard and Poor's statement on its decision to lower the U.S.'s sovereign debt rating from AAA to AA+ on Friday, but it could have been. The agencies have been taken a beating for their lack of leadership in risk assessment over the years, particularly for their failures during the housing bubble. So what happens when one of them finally takes a bold, contrarian stance? Washington and Wall Street are even angrier.

Remember 2008 through 2010?

Back when the financial crisis struck, investors threw up their hands and began screaming about the rating agencies' incompetence. How could they so foolishly believe that all of those now toxic mortgage securities were rated AAA? Why didn't their assumptions account for the possibility of a big nationwide decline in home prices? Just because it had never occurred before doesn't mean it couldn't occur under certain circumstances one day -- like as the consequence of a giant housing bubble.

Congress agreed. In hearings and panels, the agencies were harshly criticized for not better predicting the future problems in the securities they rated. How could they be so incompetent? And the worst part: they hid behind the First Amendment protection. Congress tried to put an end to that by forcing stricter liability on the agencies. But they managed to wiggle out of that requirement when the market for asset-backed securities briefly ceased as the agencies refused to rate securities due to that new liability.

Both investors and politicians considered the rating agencies a chief cause of the financial crisis. If they had instead led the market to be wary of these mortgage securities -- despite the popular views that the housing bubble wasn't going to end so badly and that home prices couldn't experience deep declines on a national scale -- then the U.S. economy might have avoided it's terrible spill. The agencies should have been bold in declaring the market wrong. That is, after all, their job: to call out the risks that others refuse to see.

Fast-forward to Mid-2011

Now think back to a more recent time: May 2011. S&P was the first to cite a dangerous precedent forming as Congress refused to compromise to achieve a significantly more fiscally responsible budget. As the debt ceiling debate raged on the other agencies began to frown as well. S&P was the most vocal, saying that Congress had better provide a solution that would get the U.S. through 2012 without having to worry about the debt ceiling, along with at least $4 trillion in deficit reduction.

Congress ended up meeting S&P halfway. At the very last minute -- a day before Uncle Sam was set to bump his head against the debt ceiling -- Washington finally came to an agreement. It upped the debt ceiling to get the U.S. through 2012, but used a scalpel to carefully slice only a little over $2 trillion from spending. In a sense, Washington called S&P's bluff: perhaps lawmakers believed $4 trillion in cuts wasn't really necessary at this time. After all, just look at Treasury yields. Despite all of the political risk growing in the halls of the Capitol, Wall Street was trading Treasuries at yields near their record low.

Presented by

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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