The Backlash Against S&P Begins

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

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.

So investors' view here is complex. Apparently, they must see the prospect of a U.S. default highly unlikely, despite the downgrade. But perhaps they believe that the U.S.'s poor fiscal position could result in a decision not to bail out municipalities that face default.

The Problem This Causes

The reactions of the federal and municipal governments are somewhat hypocritical. Back when Congress was holding hearings about all of the problems that we saw during the financial crisis, they loudly criticized lenders for cherry-picking rating agencies. They appeared deeply concerned that mortgage bond issuers pressured the agencies to provide overly optimistic ratings to ensure future business. Separately, some municipalities have criticized the agencies for not being conservative enough with their ratings, after the local governments lost money on mortgage bonds held by pension funds.

The Solution: Unsolicited Ratings

Yet even if the U.S. decided that it no longer wanted S&P to rate its debt, the agency would still do so. Rating agencies sometimes provide unsolicited ratings on important debt issuance for which they have publicly available data to base a rating. Although they don't get paid, they believe getting their opinion out there is worth doing this work for free.

But the way the market currently works, agencies can't provide unsolicited ratings for every bond out there. Ultimately, they need income to compensate their rating analysts. As a result, the possibility that issuers drop conservative raters must remain a real business concern to the agencies.

A reform was proposed to fix this problem when the financial regulation bill was being created. It would have created a panel of investors who randomly pick one agency to rate every deal, which issuers could not drop. Though, issuers could solicit additional ratings as well. Under this proposal, the agencies wouldn't have to worry as much about adverse reactions to their ratings, as the issuers would not solicit all ratings.

The agencies fought against this proposal, however, and it was ultimately dropped from the final bill. Instead, the legislation calls for a study to be completed by mid-2012 to determine such a system's feasibility. But perhaps if the agencies -- including S&P -- had embraced this rule, they wouldn't have to worry as much about getting dropped when issuing a conservative rating. Under the proposed framework, agencies wouldn't have as much of an incentive to pacify issuers.

Ultimately, the only way to end this conflict-of-interest is to reform the system. As long as issuers have all the power over who provides their ratings, bonds are doomed to suffer from overly optimistic assessments, and contrarians will be punished instead of embraced.

Image Credit: REUTERS/Brendan McDermid