Credit rating agencies are once again in the spotlight amid the ongoing high-stakes debt ceiling negotiations in Washington.
As Democratic and Republican lawmakers remain deadlocked and the approaching "X-date" looms when the US Treasury's funds run dry, there is an increasing risk of a downgrade to the United States' debt rating.
The so-called "big three" — Moody's Investors Service, S&P and Fitch Ratings — hold immense power to determine the creditworthiness of companies, state governments and even entire nations. All three agencies have signaled that they would consider cutting the United States' credit rating if lawmakers do not pass a bill to raise the debt limit before it's too late. In fact, earlier this week, Fitch issued a stern warning, placing top-ranked US credit on ratings watch negative.
Experts say an actual downgrade could shock the global financial system and threaten the US dollar's standing as the global reserve currency.
What is the purpose of credit rating agencies?
Put simply, credit rating agencies provide their opinions and issue a score evaluating the likelihood that a borrower will repay its debt. Rating agencies first rose to prominence over a century ago, but today, the three major agencies dominate the market.
The United States is one of the countries with the highest-rated debt in the world, holding a top-ranked AAA from Fitch and Aaa from Moody's. The US is ranked AA+ by S&P, which downgraded the country in 2011 during another debt ceiling fight in Washington.
How do they do it?
According to Lawrence White, a professor of economics at New York University's Stern School of Business, each agency has its own methodology to determine the financial health of companies and countries.
Overall, though, White said agencies weigh a country's economic track record, including expected revenues, costs and debt payments, to determine a score.
He said only countries that are "extremely likely" to honor their obligations get a triple-A rating.
"Their opinions are taken very seriously by financial markets," White said of the big three agencies. Entities with lower ratings generally must pay higher interest rates when borrowing money.
These agencies are not without controversy
Moody's, S&P and Fitch charge fees to most entities they rate, excluding sovereign nations like the United States, according to Samuel Bonsall, a professor at Penn State's Smeal College of Business. Bonsall has studied the effectiveness of credit rating agencies and their possible conflicts of interest.
"If I'm a corporation and I want to get a debt rating, I have to pay fees for that bond issuance rating," Bonsall said.
"There's a bit of a concern of pay for play," he added.
Bonsall said the agencies "spent up some reputational capital" in the last few decades when they failed to lower ratings before Enron's bankruptcy in 2001 and the 2008 global financial crisis.
"Perception-wise, I'm not sure how much trust the general populace has in the agencies doing a good job," he said.
A US credit downgrade would likely hurt
Nevertheless, a downgrade of the United States from one of the big three would likely hurt Americans in a number of ways, Bonsall said.
That's because a downgrade could have knock-on effects for consumers and companies, damaging the economy all around.
"It could lead to a recession happening sooner than it would have otherwise happened," he added.
White estimates that a downgrade could erode the US dollar's standing as the most trusted currency for international trade payments.
"Participants in international transactions may start saying 'we're not quite so comfortable denominating everything in dollars. We're not so comfortable holding US bonds. Maybe we should start thinking about the euro as an alternative currency for doing business,'" he said.
