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Did S&P Just Shoot Itself in the Foot?

By now everyone knows the news. Last Friday evening, Standard & Poor's (S&P) downgraded the U.S. credit rating from the highest "AAA" rating down to "AA+". It was the first time in history that U.S. municipal debt did not garner the top credit rating from all 3 major ratings services. Additionally, S&P assigned a "negative" outlook to the rating, indicating that yet another downgrade is possible within the next 12-18 months.

The implications obviously are wide reaching. Treasury bonds have always been considered the standard for "risk-free" investment, but now they are considered more risky than the public debt of Canada, France, Germany, or for that matter, the corporate debt of Microsoft (MSFT)! As a result of the downgrade, it is possible that treasury yields could increase 0.5% or more to offset the "risk". Also, of no small consequence, it is also extraordinarily embarrassing to the country and to government officials in particular.

All that aside, though, this is a site about stocks in Magic Formula Investing (MFI). As such, I want to look at effects what the downgrade may have on MFI stock McGraw-Hill (MHP), the parent company of S&P.

A Compentency Question

The first negative effect is a question of competency. On Friday evening, word was leaked that S&P was about to downgrade the U.S., but the Treasury Department informed them of a $2 trillion error in their calculation. S&P acknowledged the error... then promptly went ahead with the downgrade anyway. According to this report, S&P simply removed out their economic justifications from early drafts and instead switched to a political argument, specifically that partisan fighting and unrivaled brinksmanship over the debt ceiling deal as making government unpredictable and untrustworthy to enact promised budget cuts, or even the possibility of intentional default.

There are a few problems with the $2 trillion issue. First, S&P had for the past month stated that $4 trillion in spending over 10 years had to be cut to maintain a top rating. Congress put through a bill that is expected to cut spending by $2.1 trillion. That, plus S&P's $2 trillion whiff, would cover the obligation. So why did the agency not re-consider the cut and instead take only hours to change their thesis?

It certainly brings the compentency of S&P to the forefront. It also gives the government the high ground to bring up S&P's "AAA" ratings on worthless subprime backed mortgage debt in the 2007-08 period. Certainly, S&P brought into question their own compentency with this move.

Debt Rater or Political Commentator?

S&P's motive is also at question. A debt rating serves two purposes - it informs an investor of the likelihood of a bond not being paid off at maturity, and the likelihood of all coupons being paid in full and on time. The likelihood of the U.S. Treasury not paying its debt is essentially 0. This is the institution that can decide how much money to print, for crying out loud! Not only that, but $2.1 trllion in spending reductions were just put into law, and tax cuts totalling about $700 billion are set to expire at the end of next year.

S&P is not giving the government a chance to do what is necessary. Competitor Moody's (MCO) took a much more reasonable approach, issuing sharp warnings that promised spending reductions had to be enforced, or face a rating cut next year. Moody's left the rating at their top, "Aaa" rating.

If the likelihood of not getting paid back is 0, how can a bond not be AAA rated? S&P comes off looking more like a political commentator than a financial analyst. That's not the firm's charter.

Putting the Noose Around Their Own Neck

Make no mistake - the ratings agencies got off easy in financial reform, considering their part in the crisis of 2008-09. In fact, there was very little visible new regulation, and the ratings oligarchy of S&P, Moody's, and Fitch remains to this day.

This downgrade really ticked off some powerful people. It is not inconcievable that Congress will now once again look a little more aggressively into the ratings business. In fact, the Senate has announced a review into the downgrade. While there have been no new legislative efforts or hearings around the agencies, I wouldn't be surprised to see some retaliatory action taken. That would not be good for S&P, and by extension, McGraw-Hill.

Investor Scorn

Last but not least, McGraw-Hill will probably face some backlash from investors. Some will sell the stock because of the risks outlined above. Some will sell out of emotion. Some will sell out of frustration that the downgrade has triggered a massive sell-off. Look for valuations on the stock to trend lower for some time.

At the end of the day, this was just a unilateral action that did not need to be taken at the current time. S&P should have laid down stern warnings and taken a wait-and-see approach on the latest spending reduction bill. Another year on this could have saved the company, and its stockholders, a lot of potential headaches in the near to medium term.

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