Blogs & Comment

Why listen to S&P?

After an unprecedented downgrade of U.S. debt, Standard & Poor's finds itself in the cross hairs.

A man looks at the stock price monitors at the the BM&FBOVESPA Stock Market in Sao Paulo, Brazil, Monday, Aug. 8, 2011. (Photo: Andre Penner/AP)

The downgrade of America’s credit rating by Standard & Poor’s was inevitable in many ways, and yet the announcement still hit with all the impact of a bomb blast. Markets today are reacting with predictable nihilism. Equally predictable has been the official response from the U.S. Treasury Department, which sought to attack the credibility of S&P.

The vindictive reply from the Treasury is a classic case of shooting the messenger, though S&P did not do itself any favours by understating the dollar amount of deficit reductions by US$2 trillion, a math error the Treasury pointed out and S&P acknowledged. But as the agency stated, its decision to downgrade was not based exclusively on metrics, but on the increasingly dysfunctional political situation in the U.S. at a time of huge economic and financial challenges. The debt ceiling debacle showed all too clearly how chaotic Congress really is. “The political brinksmanship of recent months highlights what we see as America’s governance and policymaking becoming less stable, less effective, and less predictable than what we previously believed,” the agency wrote in its assessment.

Underlying the Treasury’s response, however, is a valuable question: Why does the opinion of S&P carry so much weight? And should it?

S&P is only one of countless institutions that issue opinions on the economy, but it is more influential simply because it enjoys official status in the U.S. as a Nationally Recognized Statistical Ratings Organization (NRSRO). In the eyes of the U.S. government, S&P is a credible and reliable organization. As such, its decision to downgrade the U.S. is “perhaps the most incredible example of biting the hand that feeds you ever seen in financial history,” writes Dan Alpert, managing partner of New York investment bank Westwood Capital.

Alpert argues S&P, regardless of its NRSRO status, lost credibility in the subprime mortgage meltdown. This is the same organization that issued triple-A ratings to complicated financial products that ultimately exploded and led to the financial crisis we’re in now. “Standard & Poor’s, before you go about decrying the messiness of your country’s legislative houses,” he writes, “clean up your own house.”

Robert Reich, former labour secretary under Bill Clinton, argues much the same. “Had Standard & Poor’s done its job over the last decade, today’s budget deficit would be far smaller and the nation’s future debt wouldn’t look so menacing. We’d all be better off had S&P done the job it was supposed to do, then.”

Reich paints the agency’s act as an “intrusion into American politics.” S&P should stick to assessing credit risk, which comes down to whether or not the U.S. can pay its bills. So far, that’s what the country has been doing, which makes the downgrade unfair. “A pity S&P is not even doing its job now,” he writes.

Such a claim may be disingenuous. Assessing political risk should be a necessary component when scrutinizing sovereign debt. Certainly investors do it, so why not rating agencies? As Felix Salmon at Reuters points out, “all sovereign defaults are political, not economic….sovereign ratings are always going to be a judgment as to the amount of political capital that a government is willing and able to spend in the service of its bonded obligations.” To discount politics when examining sovereign debt is simply negligent.

If anything, S&P is taking its rating duties far more seriously than it has in the past. During the mortgage securities boom, S&P was slapping triple-A ratings on worthless and complicated products without bothering to fully understand them. The problem was the agency was far too liberal in applying the most coveted of ratings. Now, however, S&P appears keen not to repeat the same mistake, and is incorporating all forms of risk—including political—into its ratings.

Expect questions about the authority of S&P to intensify over the coming months, as the government and the agency remain at odds about the country’s fiscal situation. That has been the case in Europe, where politicians tend to characterize downgrades as “attacks” on their countries. Just last week, police in Italy raided the offices of S&P and Moody’s as part of an ongoing investigation sparked by consumer groups who complained last year when Moody’s issued a negative report on the Italian banking system.

These questions may ultimately distract from the real problem of America’s dire fiscal situation. “Forget Treasury’s $2 trillion smear campaign,” writes Scotia Capital economist Derek Holt in a note today. “That’s the side issue driven by a ‘You can’t downgrade America’ mentality from government, media and some elements of the U.S. corporate landscape.” 

S&P is far from a perfect organization, but in this case, Holt agrees with the agency that the planned austerity measures in the U.S. are too far down the road and too open to change by a dysfunctional Congress to have an impact on the country’s finances. This downgrade might not be the last one, either. “This may well be the first downgrade to sweep through U.S. credit markets…the U.S. is now going down Europe’s path.”