S&P downgrade: The collision of Washington and Wall Street

By Stephanie Condon

Lucy Nobbe, a broker from Missouri, was frustrated by the nation's political and economic woes. But when she couldn't take out her frustrations on Washington, she lashed out at Wall Street.

After credit rating agency Standard and Poor's made the stunning move of lowering the United States' credit rating, Nobbe forked out a few hundred bucks to send a message: She paid for a plane to fly over Wall Street with a banner that read, "THANKS FOR THE DOWNGRADE. YOU SHOULD ALL BE FIRED!"

"I originally wanted to fly it over Washington, D.C., but learned that you can't do that," Nobbe told Fortune. "So I chose Wall Street instead, but didn't specifically intend it to fly over S&P. I'm just a mother from St. Louis who feels the only reason we got downgraded was people in politics."

Given the correlation between the state of the economy and politics, one could be forgiven for interchanging Wall Street with Washington -- particularly when most Americans think politicians pay too much attention to corporate interests.

To many Americans, S&P's decision to downgrade the U.S. from triple-A to double-A plus felt like another corporate betrayal of Main Street America. The decision appears all the more questionable now that one of S&P's main competitors, Fitch, has reaffirmed its triple-A rating of U.S. debt.

"Much of the American public thinks S&P is a traitor to the country and the Benedict Arnold of rating agencies," said Columbia University law professor John Coffee. "I think there's an element of blaming the messenger in all of this."

That's not to say Americans don't have good reason to feel betrayed. S&P's move sent the stock market on a roller-coaster ride of uncertainty. And while the U.S. bond market hasn't suffered, the effects are still far-reaching -- for instance, thousands of municipalities with debt closely tied to federal creditworthiness were downgraded, which could impact financing for projects like a high school in Montana's Hill County.

 Furthermore, the downgrade stung more knowing that S&P and its brethren were in part responsible for the nation's financial woes in the first place -- it was the major rating agencies that slapped triple-A ratings on bonds backed by nearly worthless subprime mortgages, lulling investors into a tragically false sense of security. In fact, the New York Times reported on Wednesday night that the Justice Department is investigating whether S&P improperly rated mortgage securities in the years leading up to the financial crisis.

Perversely, some charge that S&P's decision to lower the U.S.'s rating may have been motivated in part as compensation for its past lax oversight. "Right or wrong, it was a gutsy call," said Coffee. "I suspect this may have been an effort by S&P to reestablish their reputation."

But while the rating agency may have been trying to boost its image, policymakers say the incident only puts new focus on the flaws of the credit rating industry -- flaws the government should fix if Main Street wants more protection from Wall Street. Chiefly, according to Coffee and some lawmakers like Rep. Brad Sherman, D-Calif., Washington should fix the conflict of interest built into the ratings industry. Ratings agencies are typically paid by the issuers of debt for which they give ratings. The U.S. government doesn't ask for a rating, and doesn't pay for it.

"We're the only student not paying the teacher -- and we got the bad grade," said Sherman, a member of the House Financial Services Committee.

The backlash

To be sure, a double-A plus rating is still considered very strong (in the corporate world, only a handful of companies still have triple-A ratings). And S&P certainly can point to real problems, such as the level of U.S. debt compared with the nation's economic output, to justify its call.

Still, S&P's decision left many politicians, regulators and pundits scratching their heads.

To begin with, it is impossible for the U.S. to default on its loans unless it chooses to do so, since the Treasury prints its own money. And since Congress raised the debt ceiling by the time S&P issued its downgrade, the threat of default was completely off the table.

On top of that, the rating was issued even after the Treasury Department pointed out that S&P made a huge accounting error -- to the tune of $2 trillion dollars -- leaving the rating agency to use subjective political analysis as its main rationale for the downgrade. A Treasury official said the mistake raised "fundamental questions about the credibility and integrity of S&P's ratings action."

 The Securities and Exchange Commission is investigating the agency's questionable math, as well as whether the company leaked word of the decision before it was publicly announced, according to Bloomberg.

Meanwhile, the Senate Banking Committee is gathering information on the downgrade, while some lawmakers are calling for hearings into the company's motives.

S&P did not respond to Hotsheet's questions regarding the criticism surrounding the downgrade. But in an interview with The Wall Street Journal earlier this month, S&P President Deven Sharma said the rating cut was in the best interest of investors. "Our ratings are forward-looking," he said. "And part of making ratings forward-looking is for the benefit of investors, to give them a view about how we see the future risks of the credit unfolding."

Pundits and activists started targeting S&P even before the downgrade was official. Just the threat of a downgrade was enough to influence the Washington debt debate, prompting pundits on the left to derisively call the rating agencies the "masters of the universe, and leaving conservative pundit Michelle Malkin asking, "Since when did politicians pledge allegiance to S&P's and Moody's?"

Even some in the private sector started a campaign against S&P -- albeit anonymously. Last week, communications and government relations firm Sphere Consulting launched the site www.getSandPoutofpolitics.com at the behest of five unnamed CEOs of large manufacturing companies.

Jim Courtovich, managing partner of Sphere Consulting, said the downgrade "has a very negative impact on the overall economy, which of course has a direct impact on their industry and their companies." The decision to downgrade U.S. credit "just doesn't add up," he added, and his clients are interested in adding some context and historical perspective to the discussion. The site culls articles and information that take a hard look at S&P and its role in the government, and Sphere Consulting regularly emails the information it collects to Capitol Hill policy makers.

So why are industry leaders who are calling for more transparency from S&P remaining anonymous?

"There's a retribution factor," Courtovich said. "It's hard to get in an argument with the people who are rating you."

Many feel that's exactly the predicament the U.S. government faces.

Retaliation?

Policy makers were in the midst of overhauling the rating agency industry, chiefly through the Dodd-Frank Act (Mr. Obama's Wall Street reform package), when rating agencies started issuing warnings of a possible downgrade.

Some are charging S&P downgraded the U.S. to "bully" the government -- to ward off regulatory action against its role in the 2008 financial crisis, or in retaliation for the Wall Street reforms, with the intention of fending off new rules that have yet to be implemented.

Watch a discussion on Washington Unplugged with John Taylor of the National Community Reinvestment Coalition about the Justice Department's investigation into S&P and whether it's retribution for the downgrade of U.S. debt, in the video at left.

"Whatever S&P's agenda, it has nothing to do with avoiding default risks or putting the US on sound fiscal footing," wrote liberal activist Jane Hamsher, of the site FireDogLake. "It appears to be intertwined with their attempts to absolve themselves from responsibility for their role in the 2008 financial crisis, and they are willing to manipulate not only the 2012 election but the world economy to escape the SEC's attempts to regulate them."

Sherman doesn't believe the U.S. credit downgrade was an act of "retaliation."

"It is rare that a corporation tries to retaliate against the U.S. government," Sherman said. Still, he added, "S&P's perhaps one of the few in a position to do so."

But while he may not consider the downgrade retaliation, Sherman said it does appear to him to be tied to the 2008 crisis. "One might say they were trying to get back their reputation as a tough grader," Sherman said, echoing Coffee's conclusion.

Had S&P made the right call in 2008 by downgrading questionable bank holdings, rather than downgrading the U.S. now, Sherman said, S&P "would've lost some clients, and we would've avoided a recession."

Conflicts of Interest

Downgrading bank holdings could have cost S&P business, as Sherman suggests, because of the way the rating agencies make a profit.

Moody's and S&P have been rating businesses' creditworthiness for over a century. S&P is by far the largest of the ratings agencies. It was acquired by McGraw-Hill in the 1960's, and the combined revenues of S&P and McGraw-Hill Financial in 2010 came to $2.9 billion.

Initially, banks, libraries and other entities would pay a subscription fee for a published list of ratings. That business model worked well enough until about the 1970's, but it went out the window with the advent of the Xerox machine.

At that point, Moody's and S&P started charging entities for receiving a rating. This worked in large part since the government required banks to use ratings when issuing debt and setting capital levels. However, the system set up an inherent conflict of interest that became all too clear in the aftermath of the 2008 financial crisis.

As the world of structured finance developed, investment banks began asking for ratings on collateralized debt obligations and other financial packages at a quick pace. Investment banks soon made up a significant portion of business for credit rating agencies, making it hard for them to keep their independence. On top of that, Moody's and S&P had a new competitor-- Fitch entered the market in the 1990's.

Sure enough, the rating agencies inflated their ratings on structured debt, ignoring all of the warning signs of a looming disaster in the subprime market. After a two-year investigation, the Senate Permanent Subcommittee on Investigations concluded this year that banks including Goldman Sachs and UBS effectively pressured S&P and Moody's into altering their ratings of mortgage-backed securities.

Since then, Congress passed the Dodd-Frank Act, which in part attempts to reform the credit rating industry and curb its influence in the government and economy. For instance, the law requires all regulatory bodies to stop relying on credit rating agencies when making judgments about regulated financial companies like banks. The SEC officially started removing credit rating agency references from its rulebooks last month.

There's one potential reform that Coffee and Sherman have said could be key to improving the industry -- a provision in Dodd-Frank that calls for the SEC to consider creating an independent board that would select credit rating agencies for firms issuing securities. Firms receiving ratings would still pay for them, but they could theoretically no longer entice the rating agencies into giving them inflated grades.

Sherman initially introduced a provision to create the independent board, but only a "watered-down" version, as he called it, passed. The version that passed calls on the SEC to "study" the matter and either adopt the plan or come up with a better one by 2012.

The rating agencies, Sherman said, "had power in Congress to get that watered down, to protect their own profitability. We need to push the SEC to interpret the law and follow the law correctly."

To be clear, this reform would not directly impact the way S&P and other credit rating agencies rate U.S. debt since the U.S. government doesn't pay for ratings. Companies like S&P rate sovereign debt to maintain their high profile -- to bolster their reputation.

So, Sherman said, "In a way, the downgrade [of U.S. debt] allows S&P to show what a tough grader it is without offending any of its clients."

With the right reform, Sherman and Coffee argue, S&P could be a "tough grader" on any issuer of debt -- not just the U.S. government.