The battle over raising the debt limit put Standard & Poor’s, the world’s biggest provider of credit ratings and other ratings services in an awkward spot: They are judging the creditworthiness of the U.S. government at the same time that Congress considers rules limiting the raters’ power. “This is the definition of a rock and a hard place,” says Peter Appert, an analyst at Piper Jaffray (PJC) in San Francisco. “There’s no upside for the rating agencies in this debacle.”
Congress and federal regulators are discussing ways to implement the Dodd-Frank Act, which contains several provisions aimed at reducing the raters’ role in the financial system and creating more competition in the industry, dominated by S&P, Moody’s (MCO), and Fitch Ratings. In an April report, a Senate panel blamed raters for fueling the financial crisis, saying they engaged in a “race to the bottom” to stamp inflated grades on mortgage-backed securities.
Now, Washington is watching closely as the raters mull whether to change the U.S.’s grade. Even though Congress has agreed to lift the debt limit, S&P still may strip the U.S. of its AAA rating. On July 14, S&P cited such factors as the budget deficit soaring to 11 percent of gross domestic product, a higher level than in AAA-rated France and Germany. “We suspect they’re under tremendous pressure not to downgrade,” says Mohamed El-Erian, head of Pimco, the world’s biggest manager of bond funds. “But if they stick to what they told the world on July 14, they will downgrade.”
Moody’s, the second-biggest rater, and Fitch Ratings, No. 3, have affirmed their AAA ratings while warning that downgrades are still possible if lawmakers fail to enact further debt reduction measures or the economy weakens. “We have the people who helped cause the financial crisis now claiming that they’re experts on what the American budget should be,” says Representative Barney Frank (D-Mass.).
Dodd-Frank, passed last year, takes aim at the ratings services by directing bank regulators such as the Federal Reserve to avoid using credit ratings in making rules such as bank capital requirements. Regulators have not yet complied with that provision, in part because they have had trouble coming up with an alternate way of judging bonds.
The bind the raters are in was evident on July 27, when Congress summoned S&P’s president, Deven Sharma, to a hearing to defend his analysts’ warnings on the U.S. credit rating—and to discuss ways to implement Dodd-Frank. “Do you honestly believe that the United States could default on its debt?” Representative Francisco Canseco (R-Tex.) asked him.
The raters are “well aware of the power that politicians have” over them, says Christian Opp, a professor at the University of Pennsylvania’s Wharton School. Moody’s paid Akin Gump Strauss Hauer & Feld $610,000 this year to lobby Congress on financial regulation, while S&P’s parent, McGraw-Hill (MHP), paid Podesta Group $240,000.
The lobbying may be paying off: Last month a House panel passed a measure to repeal a part of Dodd-Frank that would make raters liable if they award a high grade to securities that turn out to be risky. Canseco says the companies are “walking a fine line” by attempting to influence policy. S&P’s analysts are separated from its lobbyists and salespeople by a “strict firewall,” says Patti Rockenwagner, a spokeswoman.
The government has been pressing its case to retain the AAA rating. Treasury Secretary Timothy Geithner and Jacob Lew, director of the White House Office of Management and Budget, met with John Chambers, chairman of S&P’s sovereign rating committee, and other S&P analysts on Apr. 13 to discuss the Administration’s fiscal-reform plan and the odds of its passing, Geithner told Congress in a letter. A Treasury Dept. spokesman declined to comment on any other conversations, as did S&P.
“It’s one thing for [raters] to be lobbied by General Electric (GE),” says Peter Morici, a professor of business at the University of Maryland. “It’s another thing to be lobbied by your government.” He says raters may be worried because the Securities and Exchange Commission is considering the feasibility of a Dodd-Frank rule written by Senator Al Franken (D-Minn.) that would set up a board with the power to assign raters to some bond issues, giving an opportunity for smaller companies to get more assignments. In Europe, politicians threatened to retaliate when raters withheld their approval of plans to rescue Greece, Portugal, and Ireland. After Moody’s cut Portugal’s rating to junk on July 5, German Finance Minister Wolfgang Schäuble said there’s a need to “break up” the big raters’ dominance.
The raters retain their role as gatekeepers in the bond market. About two-thirds of the biggest pension funds require that any bonds they buy have ratings from S&P, Moody’s, or Fitch, according to Kroll Bond Ratings, a competing firm that issued its first ratings this year. Bloomberg LP, owner of Bloomberg Businessweek, started providing its own credit ratings last year.
Moody’s revenue from rating corporate bonds rose to a record $563.9 million last year (the raters are not paid for rating U.S. debt). McGraw-Hill’s stock soared on Aug. 2 after activist hedge fund Jana Partners said it acquired a stake. The company may be pressured to split its lagging textbook unit from faster-growing S&P.
“We didn’t go as far away from the rating agency model as people expected,” says Jeff Matthews, author of Secrets in Plain Sight: Business & Investing Secrets of Warren Buffett. Buffett owns 12.4 percent of Moody’s. “Not only are companies dependent on them, but now countries are too.”