U.S. downgrade a crossroads for S&P by Katie Benner @FortuneMagazine August 6, 2011, 7:27 PM EDT E-mail Tweet Facebook Google Plus Linkedin Share icons FORTUNE — In the rating move heard ’round the world, Standard & Poor’s lowered the credit rating of the United States, saying that the country could someday miss a debt payment due to its deeply divided government. The move not only creates a huge amount of uncertainty for investors waiting to see how this plays out when markets open on Monday, it is a big gamble for S&P. The downgrade could give S&P the distinction of being the only firm willing to honestly assess the creditworthiness of a country whose politicians publicly (and flagrantly) toyed with the idea of voluntarily defaulting on debt obligations. Or the move could unleash a backlash. Investors could shun the firm and, more broadly, the government could retaliate by moving rating agency reform from the backwaters of the Wall Street regulatory overhaul to the top of the agenda. Behind the curve The longstanding criticism of the big three rating agencies — Fitch, Moody’s MCO , and Standard & Poor’s — has been that they fall down on the job with terrible results for bond investors. The agencies are supposed to assess the likelihood that a bond issuer might not pay back the money it has borrowed, but in a handful of high profile cases the companies have said that bonds are virtually risk-free nearly up to the day that the issuers default. Take for example the massive corporate defaults of the early aughts. Stock market darling Enron was rated investment grade just days before the company filed for bankruptcy under the weight of accounting chicanery and management lies. Bear Stearns wasn’t downgraded until the day it went under. Then there was the mortgage-backed securities debacle, when agencies bestowed AAA ratings — often referred to as the risk-free rating — on bonds backed by subprime mortgages, as well as the alphabet soup of structured products (ABS, CDOs, CLOs, CDO-squareds) that were issued en masse by banks during the credit bubble. Those securities were downgraded after investors lost much more money than they would have expected from a AAA-rated bond. The agencies have fought to repair their tarnished credibility in the wake of the financial crisis by fiddling with their ratings criteria and their corporate cultures. And they have been downgrading shaky looking creditors ahead of potential defaults, slashing ratings for Europe’s distressed sovereign debt issuers. S&P’s decision to downgrade the U.S. from AAA to AA+ (with an outlook negative, meaning another downgrade could be in the cards), is widely perceived as part of the larger campaign of reputation repair. Some have said that the company doesn’t have the credibility to pass judgment on the U.S. And while Warren Buffett argues that the country is actually a quadruple-A credit, there are many people who think that S&P wasn’t wrong to downgrade the U.S. “How could any sentient being think that, given all that we’ve gone through over the last few months, that the U.S. is AAA,” says Lawrence White, a professor at NYU’s Stern School of Business who has been a harsh critic of the rating agencies. “In some sense, I’m surprised it took them so long.” “The world has known for awhile we’re not AAA,” says Harry Rady, the founder of Rady Asset Management. “If you look at the U.S. balance sheet as you would any corporation, we’re not a risk free credit. This is just another acknowledgement that if the government can’t manage its affairs, the market will force it.” If the market accepts, albeit grudgingly, that S&P is correct about its assessment of the country’s creditworthiness, the the company will be ahead of the curve on the world’s most important bond issuer, the U.S. We could then see other rating agencies acknowledge that S&P was right. “Fitch and Moody’s have said they won’t downgrade the U.S., but never say never,” says Professor White. Backlash? The immediate reaction to the downgrade was that S&P can be ignored, particularly given that the rating agency made a $2 trillion mathematical error when it made its original downgrade calculations. (“A judgment flawed by a $2 trillion error speaks for itself,” a Treasury representative told the Wall Street Journal.) And it seems that the downgrade could have little effect on pricing for U.S. government debt. Asian countries have said that they will continue to hold Treasuries (although China wasted no time in using the downgrade to question the dollar’s position as the world’s reserve currency). The Federal Reserve has said that a downgrade wouldn’t impact capital requirements for banks, and the U.S. is still perceived by many as the strongest economy in a world that is struggling to recover from the global recession. “We’re the best house in a bad neighborhood, even though nobody has walked inside to notice the small grease fire in the kitchen,” says Bill Laggner, co-founder of credit hedge fund Bearing Asset Management. But there is a chance that some investors and politicians in the U.S. will want to chasten, rather than ignore, S&P. In the wake of Friday’s downgrade, a few credit market participants said that bond issuers may now choose to have their bonds rated by Fitch and Moody’s, rather than S&P, for issuing a downgrade that to them seems political and unfair. Some hope that S&P’s decision to downgrade the U.S. will create the political will necessary to compel politicians and regulators to strip raters of the protections that have long allowed them to profit even when they misrate securities. The rating agencies insist that they merely issue opinions that one can take or leave, a position that is absurd given the fact that laws and regulations force institutional investors and banks to rely on ratings to make investment decisions. After the financial crisis, when many people would have been happy to never use the big three firms again, bond issuers still had to pay them for ratings because most institutional investors must own rated securities. By law, investors and banks still used ratings to determine what bonds they could and could not hold. Stripping references to rating agencies out of regulation (which has been proposed by the SEC and the Dodd-Frank reform bill) has been stymied by bank regulators like the Federal Reserve, the FDIC, and the Office of the Comptroller of the Currency (OCC), according to Professor White, because they do not want to have to take on the responsibility of deciding whether investments held by banks are safe. “It is much easier for regulators to outsource the job of deciding what is safe for banks to own to the rating agencies,” he says. And so finance ministers around the world are now scrambling to respond to the single opinion of a company whose reputation has been laid low by years of high profile mistakes. The jury is still out on whether U.S. political intransigence (which compelled S&P to downgrade the U.S.) will continue to protect the rating agencies from any attempt to curb their power and influence. — Correction: An earlier version of this story incorrectly stated that Enron and WorldCom were rated AAA.