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What Happens If Rating Agencies Overreact?

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If history is any indicator, financial services stock prices will ultimately overreact downward.

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One of the themes that I expect will ultimately play out fully during 2008 in financial services will be "overreaction."

If history is any indicator, financial services stock prices will ultimately overreact downward.

Similarly, as the credit quality of U.S. banks and brokers deteriorates and the need for Federal intervention rises, I expect that there will be the usual demands from Congress, asking "How could this happen?!" and aimed squarely at the regulators. And this will likely result in an over-reaction of additional rules and oversight.

But this week, I think we have seen a new, and potentially more significant, response coming out of the rating agencies. And, specifically, I am referring to Moody's comments regarding a possible downgrading of the AAA ratings of The United States of America and Freddie Mac (FRE).

Putting specific views on these two specific names aside, given the heat that Moody's has been under (and likely will continue to be under), it would not surprise me that in the not to distant future "AAA" will come to be defined as "impervious to credit risk." How that translates to criteria for AA, A, and even BBB credits, however, is not so clear.

However, what is clear is that given the U.S.' banking system's record reliance on ratings (through things like Basel II and Level 3 accounting) as well as the strong rating dependence of insurance companies, money managers, etc. a significant downward shift in ratings eligibility will only further increase the cost of debt.

For those governments, corporations and individuals with leverage, none of this – the market's, the regulators' nor the rating agencies' overreaction – will be good news.


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No positions in stocks mentioned.
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