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There is a saying that the generals fight the last war, and it could apply to the financial crisis.

Right now governments are making reforms to address the gaps that lead to the global meltdown, but the process of considering and implementing these improvements itself contains conflicting interests potentially as significant as those that got us where we are. Governments like the U.S. that are considering proposals to rein in the credit agencies—including addressing conflicts of interest generated when the agencies are paid by the players looking to bring bundled debt to market—themselves rely on the agencies for credit ratings that enable the governments to issue bonds to run deficits.

Thus, to stave off restrictive regulation, the big three rating organizations, Moody’s (NYSE:MCO), Standard & Poors (owned by McGraw Hill (MHP)) and Fitch (majority-owned by Fimalac SA (OTC:FMLCF)) have an incentive to show they don’t need stricter regulation by being harsher in their treatment of governments that regulate them.

While it’s in vogue to warn that the U.S. needs to reduce spending to avoid Europe’s current predicament,1, writing in October 2009 I argued—so far correctly2that fears of hyperinflation in the United States were exaggerated. To support this argument I noted that the rating agencies favorably consider lower U.S. tax rates (by implication unused U.S. taxing power) relative to Europe in reviewing the United States’ credit rating. The political leadership the U.S. provides in maintaining international peace and security also arguably heightens U.S. creditworthiness since peace provides a climate favorable for most businesses and global trade, increasing international incentives to honor U.S. credit.

However, a by-product of pressure asserted on rating agencies by the political process to further regulate them is a potential retaliatory motive to accelerate chatter that the United States’ triple-A credit rating is at risk.

Don’t get me wrong: I applaud congressional efforts to modernize regulation of the rating agencies, which will remove one of the embedded weaknesses that precipitated the financial crisis. My point is that while this represents long-term positive change, investors should beware that passage and implementation of these new strictures may generate medium term risk that rating organizations will more aggressively question the credit ratings of the U.S. and other triple-A rated countries.

One writer has compared the relationship between Wall Street and the credit agencies' dysfunctional practices to a policeman who stops a driver and asks for his license—the cop asks the driver for his license, not the score on the road test he took to get it. 3

Similarly, the rating agencies have acquired the function of granting a license to borrow – in the case of triple-A countries at cheap rates. Consequently, threats to revoke the United States borrowing license, however unjustified, will shake markets.

Footnoes:

1. See, e.g. “Volcker: Europe’s debt crisis shows risks for U.S.,” Reuters, May 18, 2010, here.

2. “Inflation at 44-Year Low,” Wall Street Journal, May 20, 2010, p. A1, here.

3. Roger Lowenstein, “Triple-A Failure,” New York Times, April 27, 2008, here.

Disclosure: The author does not hold a securities position in Moody’s (MCO), McGraw Hill (MHP), or Fimilac SA (OTC:FMLCF).

Source: Will Financial Reform Negatively Bias U.S. Sovereign Credit Ratings?