Rating Agencies Know a Fate Worse Than the Fiscal Cliff

NEW YORK (TheStreet) -- With four days left before the federal government heads over the so-called fiscal cliff and new reports that the U.S. Treasury may hit a 'debt ceiling' by the New Year, investors have a lot to worry about.

Lingering outside the daily political ping pong between Democrats and Republicans are Wall Street ratings agencies. As Moody's (MCO), Standard & Poor's and Fitch Ratings act as quiet bystanders to ongoing budget negotiations, investors may do well to consider them as a key risk factor as lawmakers either pull together a last-minute deal before the cliff deadline or allow the U.S. economy to hurdle over it.

Notably, Moody's, S&P and Fitch have spent recent months telegraphing to investors how they would react to a multitude of different budget scenario's. Interestingly, while heading over the cliff would appear to be the worst possible outcome for investors, ratings agencies outline why they think differently.

Moody's said in recent review of the U.S. government's debt rating that a last minute deal, which kicks the can down the road on revenue increases, spending cuts, or both, would be the worst possible outcome. Meanwhile, Fitch sees a negotiation that spills into 2013 as reason to reconsider the government's rating.

Unfortunately for investors both scenario's appear to be in the cards, given the limited amount of time Congress has to negotiate a so-called Grand Bargain this year.

On Thursday, Senate Majority Leader Harry Reid said it "looks like" Congress wouldn't be able to broker a cliff-avoiding deal by year-end. With House Majority leader John Boehner sidelines by a Republican congressional camp that couldn't approve his "Plan B" budget deal, the dimming prospect of a Senate leaves lawmakers with few options.

President Obama said on Dec. 21 that in the absence of a deal, Congress should at least put together a bill to maintain tax cuts on those earning less than $250,000 a year, while extending unemployment benefits for roughly 2 million workers.

According to rating agencies, heading over the fiscal cliff might have a similar impact for the U.S. government as a so-called Grand Bargain, which could capture the revenue increases Democrats are pining for and the spending cuts Republicans continue to hold out on.

Moody's said in September it may downgrade the U.S. debt rating from Aaa - its highest rating -- to Aa1 by 2014 if budget negotiations during the 2013 Congressional legislative session fail to stabilize the federal debt to GDP ratio. Currently, Moody's holds the U.S. government's Aaa rating with a "negative" outlook, signaling that a rating review would likely yield a cut.

Interestingly, Moody's sees the prospect of a ratings benefit if the U.S. were to fall off the fiscal cliff.

"[If] the "fiscal cliff" strategy is adopted to achieve debt stabilization - involving a large, immediate fiscal shock that would improve government finances in the short term but likely result in recession and higher unemployment - we would maintain our Aaa rating with a negative outlook and await evidence that the economy could rebound before considering a return to a stable outlook," wrote Steven A. Hess and Bart Oosterveld of Moody's in a November reiteration of the agencies ratings review.

In contrast, were lawmakers to broker a fiscal cliff deal that kicks the can down the road on debt reduction without outlining specific budget stabilization plans, Moody's hints at a possible downgrade prior to 2014.

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