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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."

Yes. Well-known.

"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.

1. Regulations 
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.

Absolute power
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.

Fool contributor Morgan Housel owns B of A preferred. Moody's is a Motley Fool Stock Advisor selection. The Fool owns shares of Bank of America and Moody's. Through a separate Rising Star portfolio, the Fool is short Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Read/Post Comments (16) | Recommend This Article (32)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 19, 2011, at 5:04 PM, aurreth wrote:

    Damn you morgan, you always know how to magnify the things that most people (especially me) read\hear about and put them in perspective. I love your columns, man!

  • Report this Comment On April 19, 2011, at 5:30 PM, Borbality wrote:

    I freaked when I woke up and saw things down more than 2%, but the actual "sell off" ended up being pretty tame considering the volatility of the last couple years. We've had bigger drops on seemingly NO news.

    I am not doubting that the selloff was mostly initiated by this S&P BREAKING NEWS ALERT OMG THE US HAS DEBT ISSUES, but sometimes it seems like the financial media just want to attribute SOMETHING to the day's market without really knowing for sure.

    But great column as usual.

  • Report this Comment On April 19, 2011, at 5:50 PM, pastreet wrote:

    Gotta love this kind of irrational response to a set of facts we were already familiar with.

    It's no surprise that the US is deeply in debt and has an income and expense mismatch that is only predicted to get worse.

    Will the continue? Yes, it likely will. The only choice to correct the financial cliff we're headed for as a country is to raise corporate tax rates as well as individual income taxes while cutting entitlement programs.

    I think a core component of the problem is years of pandering to corporate lobbies and the wealthy. This kept tax revenues low, while the government simultaneously got us involved in 3 wars, and witnessed an unprecedented increase in government spending.

    As a nation we will no doubt recover from this economic situation, but not until we suck it up and realize that we will all have to sacrifice: corporations, the wealthy, and likely even the less fortunate.


  • Report this Comment On April 19, 2011, at 6:27 PM, Bert31 wrote:

    This Monday was a great buying opportunity, thank you ratings guy! Stocks on sale, picked up some AAPL cheap

  • Report this Comment On April 19, 2011, at 6:30 PM, invafl wrote:

    How do we know that this was NOT done intentionaly, in order to SHORT the market???

  • Report this Comment On April 19, 2011, at 7:00 PM, EthanF wrote:

    This reminds me of a film called Mondivino, which is a parrallel of the wine industry in comparison to this. So does Moody's count anymore?

  • Report this Comment On April 19, 2011, at 7:29 PM, CMFMLove wrote:

    I would like to thank S&P for giving me the opportunity to buy some great stocks at a 2% discount.

  • Report this Comment On April 19, 2011, at 9:11 PM, ynotc wrote:

    Yes you are right. We don't really have any problems its just those damn ratings agencies. Full speed ahead and don't worry about the iceburgs. This ship is unsinkable.

  • Report this Comment On April 19, 2011, at 9:43 PM, KenStokes29 wrote:

    The only bit of news to take away from this is that S&P isn't afraid to downgrade the US. I took it as a bit of a warning shot, hopefully Congress and the administration look at what happened to the market on what wasn't a downgrade and realize what trouble they're in if an actual downgrade occurs.

  • Report this Comment On April 20, 2011, at 12:04 AM, TerryHogan wrote:

    I remember when that chinese rating agency (Dagong?) rated sovereign debt in the summer and they had the US ranked below AAA, a lot of people pooh-poohed it as propaganda. I can't believe it's taken this long for S&P to put a negative outlook on the US. I only wish that Washington would pay attention.

  • Report this Comment On April 20, 2011, at 7:49 AM, JaneBond wrote:

    Kind of funny how the same ratings agencies assured the market three years ago that the garbage Wall Street was peddling was AAA.

  • Report this Comment On April 20, 2011, at 7:52 AM, DanCorp wrote:

    US, UK and any other country failing to perform should be downgraded; when you read comments such as:

    "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."

    To be 'AAA' rated should mean something and be based upon stringent critera. Anything other than short-term deviation from this should be down-graded, regardless. As much corruption as existed between ratings agencies and banks to cause the 'crunch' ...there's equally as much 'dodgy dealing' in place on part of the ratings agencies in preserving the ratings of economies they have a vested interest in, i.e. their own. This is why there should be clear-cut rules as to what quantifies a rating.

    A while back a notable economist criticised the Euro as a 'weak and flawed currency' ...upon reading their argument, the underpinning reason was one thing, in the way the currency was set-up, it didn't allow for borrowing more than you can earn! ...In many respects, all these things are quite simple, if bound to transparent rules but it isn't in governments interests to do this.

  • Report this Comment On April 20, 2011, at 9:01 AM, jasenj1 wrote:

    I'm tracking a similar issue with ABAT. Previously unknown "research firm" posted a scathing critique of the company while clearly claiming to be short on the stock. The stock took a 40% dive and hasn't recovered. And now other analysts are downgrading the stock due to "investor uncertainty" and other vague notions.

    I took the opportunity to pick up some shares.

    The market is not Foolish. Doing a bit of homework can reveal healthy companies that the market has devalued irrationally. Whether they'll ever reach a rational valuation is debatable.

  • Report this Comment On April 20, 2011, at 12:28 PM, newageinvestor wrote:

    Amen. And with your thoughts in mind I picked up a couple of stocks pretty cheaply on Monday!

  • Report this Comment On April 20, 2011, at 4:17 PM, deckdawg wrote:

    SInce S&P was soundly asleep heading into the 2008 crash, I'm wondering how bad things must actually be to have aroused them now. A 30% sell off might have been a more realistic reaction.

  • Report this Comment On April 21, 2011, at 9:43 AM, rhutmacher wrote:

    "When investors lose confidence in a bank, it doesn't matter if they're right. The fate is already cast."

    Although frustrating, its an excellent point.

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