Every time another ratings agency downgrades a company’s stock, share prices plummet. And every time a ratings agency downgrades another Euro-zone nation, down go its treasuries, the markets, and the general mood of its citizens. So what will happen if Moody’s (NYSE:MCO) and Standard & Poor’s (NYSE:MHP) follow through on their threats and downgrade the U.S. from its top credit rating, and should we care? Let’s start at the beginning:
What exactly are ratings agencies? Ask anyone who’s been upgraded or has a top credit rating and they’ll be ready to extol the virtues of ratings agencies and the formulas they use to differentiate the successful from the failures. But ask anyone who’s felt the repercussions of a downgrade, and they’ll tell you a very different story, one full of woe and a few choice expletives. What they won’t tell you is how agencies like Moody’s (NYSE:MCO) and S&P (NYSE:MHP) determine their ratings and why they have such an impact on the markets.
In the case of bond ratings agencies, their job is to do the dirty work, research the securities that investors can’t be bothered to look into for themselves. They review tens of thousands of different debt securities and tell investors which to buy, and relatively uninformed investors listen because at least the agencies know more than they do. But that doesn’t mean that the ratings are always that informative, or accurate. One only has to look at the ratings of major financial firms right before they toppled the economy in 2008 to see that ratings agencies don’t always know what they’re doing.
Ok, but what about downgrading entire countries? You’d think they’d try to be a bit more responsible when the fate of an entire country is in their hands, but that doesn’t seem to be the case. Whether their ratings are accurate is not at question here. For argument’s sake, we’ll say that Greece, Ireland, and Portugal all deserved their downgrades. What then? Downgrades might give investors a warning to pull out, but they might also hinder efforts to right the country’s financial situation just when they’re teetering on the brink of collapse. Greece has narrowly escaped default so far, but with the world’s lowest credit rating, you wouldn’t know it.
But we still need those credit ratings to make informed decisions, right? Wrong. While we have to rely on ratings agencies to review things like mortgage-backed securities, such is not the case when it comes to countries like the U.S., which has analysts all over the world looking over its financial information, which is largely made public on government websites for anyone to peruse. And who’s to say Moody’s or S&P are better able to make a meaningful analysis of that information than anyone else? We all know the U.S. is at risk of default if lawmakers can’t come to an agreement on raising the debt ceiling, and we don’t need ratings agencies to tell us so. Plus, if the U.S. government does go into default on August 2, it won’t be because our finances are in such dire straits. Yes, we have a lot of debt, but such has been the case every year for quite some time now, and yet we’re still kicking. No, it’s simply politics, that dirty, eight-letter word that so often gets in the way of actually accomplishing anything. Any deficit-reduction deal that could come out of Congress would be an improvement, and it doesn’t need to be the $4 trillion proposed by President Obama. Yes, it would be nice to be out of the shadow of our massive debt, but the world’s largest economy won’t suddenly collapse if we go into default. That is, unless we get downgraded.
But I thought you said credit ratings were superficial and didn’t really matter? For the most part, that’s true. Unfortunately, any credit rating downgrade has the potential to raise borrowing costs for the U.S. and for loans using the Treasury rate. Furthermore, some money managers are contractually restricted to AAA-rated investments (NYSE:TLT), and would consequently have to dump their Treasuries, which would disrupt global markets. Those are some very real problems that could be effected by the U.S. losing its AAA rating that have nothing directly to do with the actual worth of U.S. Treasuries or the state of the government’s finances.
I’m confused, should I worry? The simple answer is ‘yes’. Lawmakers clearly need to come up with a deal soon in order to avoid default, which would have its own far-reaching implications. But if they succeed in doing so, that might not be enough to prevent a downgrade, and just as the government and economy are getting back on track, ratings agencies could jump in and mess things up. While it would be foolish to heed what ratings agencies say about the U.S.’s credit, many will, either by choice or by obligation, giving it significant power to obstruct U.S. recovery efforts and just be a general pain in the ass.