Still the Most Powerful Companies in the World

Moody's (NYS: MCO) has a market capitalization of $8 billion. McGraw-Hill (NYS: MHP) , which owns Standard & Poor's, is valued at $13 billion.

But these numbers don't come close to explaining their actual value. These two rating agencies could be worth trillions of dollars to the American people.

And that isn't an exaggeration.                

Amid the debt-ceiling circus, both rating agencies have indicated that America's credit could be downgraded shortly if Washington can't forge a deal to raise the ceiling and rein in future deficits. Even those who think an actual default is unlikely are warming to the increasing odds of a credit downgrade.

What might happen after a downgrade?

No one knows. It's never happened here before. What's likely is that interest rates will rise. And with a country as large as ours, and with the amount of debt we carry, even a small jump makes a big difference. Trillions.

This week, a JPMorgan analyst reckoned that a credit downgrade from AAA to AA would push interest rates on Treasuries up by 0.7%. This seems about right: The average AAA-rated country's debt yields 3%, while the average AA-rated yields 3.75%.

The impact such a move would have on the federal budget is massive. A 0.7% rise in Treasury yields would add $100 billion a year to U.S. borrowing costs or much more than $1 trillion over a decade. For comparison, the current deficit-reduction plan put forth by House Speaker John Boehner is forecast to cut $917 billion over a decade -- an amount not nearly high enough to prevent the rating agencies from issuing a downgrade. Most attention in recent weeks has been aimed at how much either party plans on reducing the deficit. At this point, the rating agencies hold far more sway.

It doesn't end there. By JPMorgan's calculations, the rise in Treasury rates could slow GDP growth by 1% a year. As a rough rule of thumb, every 1% of GDP growth is worth just under 1 million jobs. Over a decade ... well ... you get it.

None of this would come from the actions of elected policymakers. It would come from a very small group of private rating agency analysts, none of whose names you would recognize, and none of whose track records are worth writing home about.

Of course, one can hardly blame the rating agencies for threatening a downgrade. They are simply reacting to a dysfunctional government and deficits that are unsustainable. This is a case of don't shoot the messenger.

The danger is in the market's dependence on these ratings. Part of this reliance stems from regulations that required banks, money market funds, and the like to use officially sanctioned agencies -- Fitch, Moody's, and Standard & Poor's being the only notable candidates -- when calculating capital requirements. These rules were partially pared in last summer's overhaul of financial regulations, but investors around the world still give tremendous weight to the rating agencies' opinions.                          

Why is somewhat of a mystery. The agencies' uncanny ability to get things wrong was brought to light during the housing bust. True, the rating of sovereign nations is done by a different group than those who rated housing securities, but this gives little solace. The sovereign nation group is hardly infallible: Ireland was rated AAA until 2009; Greece held an A rating until the same year. Both are now somewhere between dead and dying.

One reason why rating agencies' opinions are still treated as the gold standard might be because it lets investors abdicate their responsibility as analysts. After the housing bubble burst, investors who bought subprime bonds were treated as victims rather than dimwits. These were AAA-rated securities, after all. Peter Lynch once remarked that professional stock pickers love holding companies like Intel (NAS: INTC) and IBM (NYS: IBM) because they won't be scolded when things go sour -- if Big Blue stumbles, it's the market's fault, not the stock picker's. If the U.S. defaults next week, bond managers holding Treasuries need not worry about wrath from their investors. All they have to do is note that these were AAA-rated securities, and the blame is passed.

What does all of this make the rating agencies? I never get tired of saying this: It makes them the most powerful companies in the world.

At the time this article was published Fool contributor Morgan Housel doesn't own any of the companies mentioned in this article. Follow him on Twitter @TMFHousel. The Fool owns shares of and has bought calls on Intel. Motley Fool newsletter services have recommended buying shares of Moody's and Intel, as well as creating a diagonal call position in Intel. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Copyright © 1995 - 2011 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.


Increase your money and finance knowledge from home

Investing in Emerging Markets

Learn to invest in a globalized world.

View Course »

Socially Responsible Investing

Invest in companies with a conscience.

View Course »

Add a Comment

*0 / 3000 Character Maximum