Don't let it get away!
Keep track of the stocks that matter to you.
Help yourself with the Fool's FREE and easy new watchlist service today.
Monday morning. Nine o'clock. Everything's calm in the global finance world.
Then Nikola G. Swann, a relatively unknown analyst at Standard & Poor's, downgrades the United States' debt outlook from stable to negative. He puts the odds of an actual downgrade -- losing the AAA seal of approval -- at 1-in-3 within the next two years.
Markets panicked. Stocks took a big hit. Gold rose. Treasury yields actually fell, but who knows what that means. The Federal Reserve is buying up to 70% of Treasury issuance. Nothing that market does should be taken seriously.
What's interesting is what S&P's report said. Or rather, what it didn't say. There was nothing shocking in it. Nothing bold. Nothing new. It didn't even include many numbers. Just a rehash of what's been reported ad nauseum over the past three years.
"More than two years after the beginning of the recent crisis, U.S. policymakers have still not agreed on how to reverse recent fiscal deterioration or address longer-term fiscal pressures."
"In 2003-2008, the U.S.'s general (total) government deficit fluctuated between 2% and 5% of GDP. Already noticeably larger than that of most 'AAA' rated sovereigns, it ballooned to more than 11% in 2009 and has yet to recover."
Right. It's been in all the newspapers.
"We see the path to [political] agreement [on reducing the budget] as challenging because the gap between the parties remains wide."
Mmm, think I've heard that one before.
This isn't a critique of S&P. Rather, it's a critique of the market's reaction. Two weeks ago, it was discovered that PIMCO's Bill Gross -- one of the world's foremost bond authorities -- was short Treasury bonds. Markets didn't so much as blink. But when one Nikola Swann rehashes what's already widely known, it shuddered.
Some might still take the ratings agencies seriously. But there may be a couple other reasons investors panicked after S&P's call.
For years, banks have been required by regulators to set aside a specific amount of capital based on how risky their balance sheets were. Who determines that riskiness? A ratings agency blessed by the Nationally Recognized Statistical Rating Organization. Only a handful of these organizations exist, and the only two large enough to be relevant are Moody's (NYSE: MCO ) and S&P. The ratings these two place on various securities dictated the amount of capital banks like Citigroup (NYSE: C ) and Bank of America (NYSE: BAC ) set aside. Higher ratings, less capital. Lower ratings, more capital (and less profits). This gives ratings agencies enormous power -- power that, over time, they've proven quite unworthy of. Last summer's Dodd-Frank financial overhaul bill reduced banks' reliance on NRSRO agencies, but international Basel bank regulations still require banks to use them to determine capital ratios. Even if markets don't take S&P's ratings seriously, the impact those ratings could have on the banking industry force investors to react.
2. Last man standing
Investors don't always react based on what they think. They react because they anticipate how others will think. Even if a hedge fund doesn't take S&P's report seriously, he or she may sell in anticipation of others taking it seriously. This is especially true in the bond market, where confidence means everything. U.S. Treasuries are safe as long as other investors continue buying them. If others lose confidence, those valiantly riding out the storm can get crushed. That was one of the biggest lessons of the financial crisis: When investors lose confidence in a bank, it doesn't matter if they're right. The fate is already cast.
Whatever the reason, Tuesday's sell-off highlights something I think most investors underestimate. S&P and Moody's might be the most powerful companies in the world. When brief remarks of an unknown analyst at a company with a poor track record violently move markets, something isn't right. S&P and Moody's obtained tremendous influence over the years thanks mostly to the government-sanctioned duopoly on the ratings industry. New laws have tried to restrict those powers, but it seems to little avail. Yesterday provided a stark reminder: Our fiscal future might not be in the hands of Congress or the president. It might rely on the whims of the ratings agencies.