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.

Unfortunately, S&P wasn't bluffing. On Friday, it downgraded the U.S. sovereign debt rating for the first time in history. The move shocked and angered some investors. Perhaps the most famous investor of all, Warren Buffett, said that the rating "doesn't make sense."

Washington is even angrier. The Treasury has been outspoken in its condemnation of the downgrade. After finding a significant error in S&P's work, a blog post from the Treasury said that the mistake raises "fundamental questions about the credibility and integrity of S&P's ratings action." Treasury Secretary Geithner asserted that the agency showed "terrible judgment" by downgrading the U.S.

Wait, What?

But isn't this exactly the sort of action that both Washington and Wall Street had been calling for over the past couple of years? S&P had developed an opinion about a risk that the market faces -- political risk due to severe partisanship in the U.S. -- and boldly took rating action as a result. It decided to lead on this issue, instead of reacting to the market. Even though the other two major rating agencies disagree; even though the market disagrees; even though Washington broadly disagrees, S&P is standing firm in its conviction that U.S. debt should not be rated AAA.

And perhaps this is sweet justice to S&P. Both investors and politicians have broadly skirted blame for the financial crisis. Investors could have better analyzed those toxic mortgage securities themselves before investing their billions of dollars in them, blindly relying on the agencies. Washington could have made the agencies' ratings less significant over the years, instead of making them more and more important throughout finance, as they permeated throughout statues from regulation to capital requirements.

But Will S&P Be Vindicated?

Some investors and even politicians do agree with S&P. They worry that U.S. debt will eventually run into problems and that Washington doesn't have the will to venture off its unsustainable path of high spending and low taxes. We won't know if S&P and those who support the downgrade are correct for some time, however. U.S. debt is under no threat of default in the near- to medium-term. Instead, S&P's decision is based on longer-term political risk.

And it's possible that Washington could have a new motivation to reduce the deficit, in part to prove its critics like S&P wrong. If it channels its anger at S&P as greater willingness to compromise more effectively in the future, then the agency may have been proven right if its downgrade had never occurred, but the world could never know of that alternate reality.

Early Monday morning, however, the market doesn't seem all that moved by S&P's verdict. At 10:45am EST, Treasury yields had actually declined a little. The Dow opened down, but only by 10:45 it had declined by less than 350 points. That's not good, but it's hardly a bloodbath. At this point, the market seems to be displeased with, by not panicking over, S&P's downgrade.

These results imply two things. S&P has already lost so much credibility over the years, that a historic downgrade of U.S. debt isn't violently shaking the market. More importantly, however, many investors disagree with S&P: despite the downgrade few are more worried about U.S. debt on Monday than they were on Friday.

Image Credit: Jonathan Ernst/Reuters