S&P’s Warning: America at Risk!

Just for a moment … let’s travel back in time to the year 1860.

The northern and western states of the United States of America have elected Abraham Lincoln to the Presidency. The southern states, determined to protect the economic institution of human slavery, vow to raise an army and attack the federal forces as soon as Lincoln is sworn in, thereby splitting America in two and plunging it into the bloodiest conflict imaginable.

Was Lincoln’s election the most significant event in the United States in 1860? If you were living through that year, you would undoubtedly believe so. But historians who believe in the butterfly effect often note that seemingly obscure people and their ostensibly trivial activities can eventually change the world.

Consider Henry Poor, for instance. Few noticed when he, as the brother of railroad magnate John Poor, became the editor of the American Railroad Journal in 1849. And even fewer purchased his first book, an industry text entitled History of Railroads and Canals in the United States, when it was published in 1860.

Indeed, unless you were a railroad or canal historian, you were probably far more interested in the progress of the Union Army than in the path of Poor’s career. Nevertheless, Poor’s book was sufficiently successful to refocus him on a career in investment data analysis, leading him to launch the company now known as Standard & Poor’s, today’s leader in the investment ratings business.

The AAA Rating: No Risk!

How important is the investment ratings system of Standard & Poor’s, as well as the similar systems of its competitors Moody’s and Fitch? One may argue that the entire American economy, and perhaps the global economy as well, rely on the public’s trust in these systems.

For instance, investors who wish to lend money to non-financial corporations that are considered “no risk” would rely on S&P’s recommendation to buy the bonds of ADP, Johnson & Johnson, Microsoft, and ExxonMobil. Why these particular firms? Because S&P asserts that these are the only four American corporations that have maintained their cherished AAA investment ratings since the market crash of 2008.

For investors who wish to purchase the bonds of sovereign countries, S&P publishes ratings that assess the financial health of national governments. The strongest AAA rated country of them all has always been the United States, by far the world’s largest economy and the issuer of the dollar, the world’s sole reserve currency. Last week, however, S&P unexpectedly alerted the world that it was seriously considering an unprecedented downgrade of America’s sterling AAA credit rating.

Structured By Cows

On April 18, S&P placed the United States on a “negative outlook,” the mildest form of alert that an organization — in this case, the federal government of the world’s most powerful nation — is facing fiscal pressures and might default on its debt obligations. Indeed, S&P was reacting to the possibility that President Obama and the United States Congress might fail to reach an agreement on reducing the federal budget deficit.

To be sure, a “negative outlook” is far from a “credit watch,” which is an announcement that a downgrade of a credit rating may be imminent. Nevertheless, the markets were stunned at S&P’s announcement last week, and investment indices plunged accordingly. Some pundits interpreted the dramatic event as a clear warning of the danger of American fiscal irresponsibility.

Others, though, have noted that S&P itself has made some highly questionable ratings decisions lately. The firm, after all, notoriously granted AAA ratings to numerous mortgage backed securities that later proved worthless. And a set of instant messages between S&P analysts that became public during a 2008 Congressional hearing embarrassed the firm; in one exchange of messages about an investment undergoing a review, an analyst protested “we should not be rating it” while another sardonically responded “we rate every deal … it could be structured by cows and we would rate it.”

Whom To Trust?

So whom, and what, should investors trust? The warning of an investment ratings firm that has been assessing the fiscal health of industries, firms, and nations since 1860? Or the historical strength of the world’s greatest economic power, a nation that has never defaulted on its obligations and that would most likely trigger a global financial panic if it would ever decide to do so?

It is indeed difficult to imagine America defaulting on its debts. Nevertheless, back in 1980, when Ronald Reagan won the presidency on a campaign platform that excoriated the growth of a national debt that had reached $900 billion, it would have been difficult to imagine that number exceeding $13.5 trillion in the year 2010.

Henry Poor himself, having lived through the era of the American Civil War, may not have been surprised that his namesake firm would question the creditworthiness of the government of the United States. For the contemporary investment community, though, last week’s negative outlook was truly an astonishing event.