When Two Wrongs Can Make a Right

The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.

By Editorial Staff, Fisher Investments MarketMinder

NEW YORK ( Fisher Investments) -- In recent weeks, it's easy to find a lot to be frustrated about regarding markets. First, the political bickering over the debt ceiling along with associated overstatements about what would and wouldn't happen if it weren't raised. Then, following a debt limit deal, markets still sold off into correction territory. But if all this frustration weren't enough, S&P decided to push forward with a downgrade of U.S. debt -- from AAA to AA+.

There are those who have claimed -- and seemingly continue to claim -- a debt downgrade represents a fundamental negative. While we can agree this has impacted sentiment in the near term, playing a role (although news from Europe no doubt contributed) in Monday's 6%-plus selloff in U.S. equity markets, claims this will fundamentally change the U.S. economy are an overstatement in our view. Here are a few ironies to highlight why credit ratings agencies' opinions shouldn't weigh too heavily on your mind.

S&P, Moody's and Fitch have far from sterling track records. Here are three of their greatest hits for a refresher:
  • They maintained top ratings on subprime mortgage debt through 2007.
  • Lehman Brothers held a high investment-grade rating in mid-September 2008. The company failed on Sept. 15, 2008.
  • Enron, whose 2002 demise showed it to be largely an illicit house of cards, was rated investment grade until Nov. 28, 2002. But in the months preceding the downgrade to junk, the SEC began a public investigation of their finances, earnings were restated (swinging a big profit to a $586 million loss), the CFO was fired and the stock had plunged from a 2000 high of around $84 to less than $5.
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    In this light, it's more than a bit ironic credit raters continually call for governments to form a "credible plan" to reduce deficits and debt. Moreover, whatever you think of the budget deal lifting the U.S. debt ceiling, fact is it is a plan -- which is at least more credible than what existed before. (Which was no plan.) So if you take S&P's ratings at face value, increased government spending is fine to maintain an AAA rating, so long as you don't debate it. If you do, then the debate must produce what they see as a credible plan to reduce it.

    Ratings agencies are primarily charged with determining an issuer's ability to service debt. But S&P has said the U.S. economy and ability to repay aren't really in question. And you'd think a key metric in that would be mathematics. But in S&P's case you'd be wrong. It appears someone at S&P forgot to carry nine zeros (or move a few beads on the old abacus) considering they've confirmed a $2 trillion error was made in their original report. Never mind that though, because S&P stated politics was the driving force anyway.

    Assessing politics is a fine thing, save for one small caveat. S&P's downgrade is on our long-term debt (not short-term). So they're projecting today's political environment remains essentially unchanged for many years ahead. But the political environment has changed in just the last two years--and is slated to again next November. And political winds frequently shift even absent presidential elections.

    In a further ironic twist, U.S. politicians are now joining EU counterparts in blasting ratings agencies over all this -- but the oligopoly of Fitch, Moody's and S&P (and the importance many place on ratings agencies) exists primarily because the government created it. Said differently, a non-market-created oligopoly sits poised with a government charter to opine on markets. That's just plain head-scratching on a good day.

    In last year's Dodd-Frank Act, one stated goal was rating agency reform, but little actual reform has occurred. A potential reason? Having "special" ratings agencies dubbed with unique importance by Congress simplifies regulators' jobs. So there you have it: One wing of government says it wants reform, but another pushes back.

    There's little to like in the above. But the wrongs from politicians and ratings agencies can actually make a right, if it helps push fundamental reform of credit ratings agencies, allowing for greater competition and less legislative reliance on the current troika.

    (This article constitutes the views, opinions, analyses and commentary of Fisher Investments as of August 2011 and should not be regarded as personal investment advice. No assurances are made Fisher Investments will continue to hold these views, which may change at any time without notice. In addition, no assurances are made regarding the accuracy of any forecast made herein. Past performance is no guarantee of future results. A risk of loss is involved with investments in stock markets.)

    This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.

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