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We've all learned firsthand over the past two years that financial modeling, forecasting, and predicting is enormously imperfect. More importantly, we've seen what happens when reckless companies gain too much power and influence over the economy. It ain't pretty.

I'm all for free markets, just not markets that dangerously distribute power. If AIG (NYSE: AIG  ) wants to sully its balance sheet, heck, let it. That's its right. But as soon as its reckless decisions spill over and affect the entire economy, you've created a beast that's far too powerful.

Allowing one company's actions to have so much influence over the economy is terribly dangerous, and it never should have happened.

But it still is happening
A similar example that doesn't get enough attention is the credit ratings agencies. Moody's (NYSE: MCO  ) , Fitch Ratings, and Standard & Poor's essentially have monopolist power over rating debt. And it's all kinds of debt -- everything from subprime collateralized debt obligations, to the debt of Microsoft (Nasdaq: MSFT  ) and Las Vegas Sands (NYSE: LVS  ) , to sovereign nations, including the United States.

Most people know the ratings agencies thanks to their role in the financial crisis. Long story short, an absurd compensation arrangement created a system in which ratings agencies were offered incentives to give AAA ratings to just about anything you asked them to. "It could be structured by cows and we would rate it" read a now-infamous email from Standard & Poor's in 2007.

As the real estate boom heated up, clever bankers realized that an enormous market for mortgage-backed securities could be created if the ratings agencies blessed the structured finance products with AAA status. Few investors second-guessed the ratings, assuming they were calculated by wise men with all the right answers.

But that was far from reality. When the mortgage-backed securities blew up, investors realized that the opinions of ratings agencies were a joke.

Their credibility, you'd assume, should be shot. As a recent academic paper detailing ratings agencies' flaws states, "Given the abysmal performance of rating agencies, widespread reliance on ratings is no longer warranted."

Yet investors still treat them like freakin' gods
Yet the ratings agencies are still unbelievably influential. Last week, Standard & Poor's put Great Britain's credit on negative watch. Immediately, the pound sank, the stock market plummeted, its sovereign debt fell, and tremors spread to global markets, speculating that the United States' own credit rating might be in jeopardy. Gold rallied, U.S. Treasuries tanked, and the dollar sank to its lowest level in five months.

What's incredible is that no significant macroeconomic news came out. No new stimulus packages. No new bailouts. No new interest rate cuts. No political scandals. Nothing we didn't already know already. Nothing. The reaction was entirely linked to the opinion of Standard & Poor's.

That's an incredible amount of power for one company to have, especially in today's economy. Why? Because the U.S. is facing insane spending commitments that'll strain the debt markets like never before. Because the price of this debt is contingent on credit ratings, the opinion of the ratings agencies can literally dictate the terms and affect the ability of a government to raise money. In a time when the economy is counting on the durability of Treasuries like never before, the opinion of three small ratings agencies has the power to throw the market on its head.

Now, I'm not suggesting that Great Britain or the U.S. don't deserve to have their creditworthiness questioned. By golly, do they ever. Tens of billions worth of debt has been issued to cover the capital needs of Citigroup (NYSE: C  ) , Bank of America (NYSE: BAC  ) , and General Motors (NYSE: GM  ) -- a spending spree that many would like to see end. No country has the right to unfettered and profligate spending.

But when three ratings agencies -- all with serious reputational issues -- can virtually dictate the terms of the government's bank account, far too much power is concentrated in far too small an area. It's dangerous. And it should stop.

Easier said than done
What's the solution? It's not suppressing the powers of the ratings agencies. They should be able to rate whatever the heck they want and publish their opinions freely.

The flaw is having a global investment community that treats the ratings agencies like uberanalysts whose opinion is handed down from the Big Man Above.

The soundness of a country -- or a company -- doesn't change whether a ratings agency upgrades or downgrades its credit. Yet the entire global economy is wrapped up in the idea that the downgrade itself is what's dangerous. It's not worried about runaway public finances or unsustainable debt burden; it's worried that a group of analysts will simply remind everyone about it. This is akin to thinking that a disease only becomes lethal if it's diagnosed. It makes no sense at all, but the ratings agencies can still pull it off with ease. As long as some investors buy and sell based on the ratings agencies, almost everyone else has to play along.

And that makes them the most powerful companies in the world.

For related Foolishness:

Fool contributor Morgan Housel doesn't own shares of any of the companies mentioned in this article. Moody's is a Motley Fool Stock Advisor selection. Moody's and Microsoft are Inside Value selections. The Fool has a disclosure policy.

Read/Post Comments (2) | Recommend This Article (30)

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  • Report this Comment On May 26, 2009, at 5:29 PM, ST0CKTRADER wrote:

    great article. i don't think it's necessarily the credibility of the ratings agency that drives the moves on the upgrade/downgrade of a stock, but more i think due to day traders/short sellers, which will typically buy or sell a stock based on the anticipation of it going up or down that day based on current news reports. An analyst upgrade is seen as positive news for a stock and people will buy on that news, just as a downgrade will be seen as negative news on the stock and people will sell the news. If day traders are sheep, then the analysts are the shepherds.

  • Report this Comment On May 26, 2009, at 9:01 PM, edward1974 wrote:

    I agree with you the credit agencies have to much power plus how come nobody fined them or sued them for fraud????

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