The rating agencies -- Moody's Investors Service, Standard & Poor's and Fitch Ratings -- all originally served bond investors, who paid for their research. But that model changed in the 1990s to one that was funded by the syndicators and underwriter of structured financial products such as mortgage-backed securities. Essentially, bankers "purchased" the rating they desired. As a result, the performance of the ratings agencies decayed, as they were no longer judged on the quality of their analytical reviews. Second, the underwriting quality of syndicators fell, as they (not a neutral third party) were, in effect, picking their own credit ratings. The real question for the financial markets is why we even require ratings agencies to evaluate complex financial products anymore.

-- Barry Ritholtz, The Big Picture
Let me start on a critical note regarding S&P's rating credibility. Historically, the agency has tended to be backward-looking, and its questionable ratings played an important role in the last credit crisis.

I tend to side with Warren Buffett's comments -- remember this is the same agency that downgraded Berkshire Hathaway's ( BRK.A)/ ( BRK.B) debt and maintained AAA ratings on U.S. mortgage-backed securities and other structured products (to the bitter end).

For years, the ratings agencies have not acted as "arm's length" and independent entities; they have acted as financial pimps to those institutions that distribute fixed income and structured products.

S&P's credibility was further strained on Friday by a $2 trillion mathematical error in the deficit calculation, leading the Obama Administration to challenge the S&P's decision.

Morgan Stanley's David Greenlaw pointedly summarizes the criticism that will likely be levied on S&P:

I have a very hard time seeing how the S&P action will have a significant impact on markets. The only thing that has changed in the U.S. is that a bunch of Keystone Kops at S&P have issued a ratings change using bad data, questionable assumptions and political spin. To be sure, the U.S. has plenty of long-term fiscal problems that need to be addressed, but the justification for a ratings change (using the criteria that S&P itself outlined in prior reports) is severely lacking. While I suspect that markets will come to the same conclusion as I do regarding S&P's credibility, the major issue for me, is whether word of the downgrade further damages confidence on Main Street. Here are my specific concerns.
  1. The political spin is obvious in S&P's public position. According to The Wall Street Journal: S&P's conclusion "was pretty much motivated by all of the debate about raising of the debt ceiling," John Chambers, chairman of S&P' sovereign ratings committee, said in an interview, "It involved a level of brinksmanship greater than what we had expected earlier in the year." Admittedly, the process got very ugly -- but no one in a leadership position in Congress or the Administration was advocating default at any point along the way.
  2. The Treasury Department has issued an official explanation of S&P's error involving the wrong baseline. See "Just the Facts: S&P's $2 Trillion Mistake" available here.
  3. Perhaps the most outrageous aspect of the downgrade in my opinion involves the change in assumption regarding the Bush-era tax cuts. This is a massive adjustment (worth nearly $4 trillion over the next 10 years) that appeared to be slipped in at the last second to make up for the baseline error discovered by the Treasury Department.

If you liked this article you might like

How to Make Your Life Successful Just Like Billionaire Warren Buffett

How to Eat Lunch With Billionaire Warren Buffett

How to Travel in Style Exactly Like Billionaire Warren Buffett

Billionaire Warren Buffett Thinks U.S. Haters Are 'Out of Their Minds'

How to Invest Like Billionaire Warren Buffett