The Great US Debt Downgrade

Dr. Justin Robinson, Head of Department & Lecturer in Management Studies,UWI,Cave Hill

On Friday August 5 2011, while most of Barbados was partying with Rihanna, there was a loud bang, and the financial world was shaken to the core with the news that major Credit Rating Agency, Standard & Poors (S&P) had downgraded the long term credit rating of the United States of America from AAA to AA+, and with a negative outlook. This momentous decision to downgrade the USA, justified or not, may well in my opinion, hasten a dramatic reduction in the role and influence of the CRAs in global financial markets, and the financial world will be much better for it.

CRAs are private profit oriented entities that issue an opinion on the likelihood a borrower will default on its debt. The opinion is issued in the form of a letter grade, with AAA being the highest rating. The industry is dominated by Moodys Investors Services and Standard & Poors, with Fitch running a distant third. Financial economists have long questioned the value added by the CRAs. To put it simply, many argue that in good times, rating agencies upgrade borrowers, and in bad times they downgrade them. Do you really need them to state the obvious? The CRAs were much maligned for assigning AAA ratings to now worthless subprime mortgage loans, and infamously rating Enron as “Investment Grade” in the same week the company filed for bankruptcy.

Much of the power of the CRAs seems to come from the fact that the credit opinions (ratings) they issue have been written into the law and contracts in many countries. For example, by law or contractual agreement many institutions are only allowed to invest in financial instruments carrying a certain credit rating by one of the major agencies. Also, in many instances, contracts require that financial instruments posted as collateral have a AAA rating. Financial Economists refer to this as the regulatory license granted to the CRAs. In essence to be a player in many financial markets you need the blessing of the CRAs. Due to this fact, attaining or losing a certain credit rating by one of the major agencies is a major issue for many investors and financial institutions. If these laws and contracts are enforced, then come Monday, a number of contracts would have been violated and investors may be forced to sell assets, find new collateral and so on. My guess is rather than face this massive inconvenience, or rather chaos, a number of clauses will either not be enforced or simply changed to allow institutions to continue to hold US government securities and use them as collateral for all kinds of financial contracts despite the downgrade. If this happens, the regulatory license, which has the source of the power of the CRAs would have been undermined and with it some of their influence.

In addition, this decision may force investors to rely more on their judgement than on credit ratings. US government securities have traditionally been viewed as the safest investment in the world. By removing the AAA rating, S&P are in effect saying they are not. If this opinion carries weight then we should see major investors like the Chinese and other Asian governments move money out of US government securities into the now “safer” investments of Canada, France, UK, Germany, Australia, Isle of Man and every other country with a AAA rating. My own sense is that, if only because of the depth and breadth of the US government debt market, many investors will still continue to pour their money into US government debt, in effect ignoring S&P. The Chinese, for example, will now have a choice of continuing to buy US debt, buy more European debt, buy government debt in relatively illiquid financial markets or allow the Chinese currency to appreciate and undermine its export lead economic growth. I suspect they will choose to continue to buy US debt, in effect ignoring S&P and the downgrade. If money continues to pour into US government securities despite the downgrade, the downgrade may well appear meaningless, and the power and influence of the CRAs would have been undermined, with investors substituting their own judgement for that of the CRAs.

While its tempting to salute S&P for daring to downgrade the great USA, the downgrade and the likely critique will in my view serve to to expose the high degree of subjectivity in sovereign credit ratings and further undermine the credibility of the CRAs and their ratings. The USA does have serious fiscal issues and the recent debt ceiling debate does raise questions about the willingness of the USA to pay its debts and hence the probability of default. The fact that raising the debt ceiling, which was routinely done around 60 times previously, became and may well remain a political issue must have been a major factor contributing to the downgrade. However, in my opinion, the downgrade would have been far more credible if S&P had waited to see the outcome of the long term deficit reduction process set up by the US government, as part of the congressional deal to raise the debt ceiling. S&P could, and probably should have waited to see what the so- called “super committee” of congress came up with before concluding that the political process in the USA was incapable of producing a credible deficit reduction plan. This willingness to jump the proverbial gun and prejudge the outcome of Political Economy processes has been a feature of recent ratings decisions in Europe. These are very subjective calls and serves to undermine the notion of the CRAs as objective analysts of the likelihood a borrower will default.

This downgrade also leads to a number of glaring inconsistencies in ratings across the globe, which in my opinion, also serves to undermine the credibility of the CRAs and their ratings. The USA has a reserve currency and can print money to pay its debts (what economists call monetizing the debt), yet France with its generous entitlement programs, aging population and an inability to print money (due to its membership of the Euro) maintains a AAA credit rating. How do you justify that? The US Central Bank has been downgraded to AA+ as well, yet the European Central Bank with its large holdings of Greek, Portuguese, Italian and Spanish government debt, retains a AAA credit rating. How do you justify that? Can the US corporations with AAA ratings, maintain such ratings while the sovereign has been downgraded? Consistency seems require that S&p review a number of ratings around the world, but if ratings are generally reviewed downwards, has the relative rankings changed, and if not what has really changed?

While the immediate loser is likely to be President Obama, I think in the medium to long term the real loser will be the rating agencies themselves. This decision exposes the subjective nature of the ratings and will encourage investors to revoke the regulatory license granted to the CRAs and encourage investors to use their own judgement rather than slavish follow ratings. This would be a good thing indeed.

0 thoughts on “The Great US Debt Downgrade

  1. Are you saying that the current sellers of gold are misinformed or uninformed? I expect the stock markets to recover before yearend, as soon as investors realize that the world did not stop turning.

  2. @Alien: “Are you saying that the current sellers of gold are misinformed or uninformed?

    At the retail level (jewellery etc; “even if broken”), yes — the sellers are almost always at a disadvantage. That’s why there are so many buyers.

    At the wholesale level (“pure”), the buyers and the sellers are making a bet.

  3. Nikkei Opens Below 9,000 On Weak Global StocksTOKYO (NQN)–Tokyo stocks opened sharply lower Tuesday, with the Nikkei Stock Average falling 185 points, or 2.0%, to open at 8,911.

    It is the first time the benchmark index has fallen below the psychologically important 9,000 line during trading hours since March 17, when the index hit 8,639.

    The Dow Jones industrial average hit its lowest level overnight since October last year amid worsened investor sentiment in response to tumbling stocks across the world.

    In Tokyo, blue chips broadly opened lower on the first section of the Tokyo Stock Exchange, with automakers, appliance makers, precision instrument makers and banks being sold aggressively.

  4. Sorry Christopher… that was meant for Moneybrain and AOD – they do not appear to have any doubts about the direction of gold, as the people that are selling do.

  5. @AOD
    Who is your mentor?
    Silver will likely go to $100 within 3yrs and could reach $150+ eventually.
    I am certainly cautious on silver because it is an industrial metal and is viscously volatile as in 70% DROP in 2008-09.

    Gold could correct, I wrote above. I would wait for a drop before buying more. But I just reviewed a client that I placed $35k in 2002 it was worth $288k, so we were both very happy. I stand prepared to sell all my gold positions at certain prices and conditions but I am not a short term trader.
    None of my clients will lose if we sell. I made money in the last few days by owning gold, bonds and shorting stocks. How have you been doing??????

  6. @David
    Very true! I would have had a wash of clients by now if they could. Who says that where ya born dont help or hurt? Bim is still my real home. and the country and peeps in my heart.

  7. @Alien
    Stocks could have a good rally but sooner or later we are going down 30%+ and could easily revisit and penetrate the lows of March 2009. We are still in serious danger of major CAPITAL PUNISHMENT.

  8. Moneybrain, here is hoping that you are a millionaire and not just making millions for others. Good luck with the gold.

  9. @Alien
    I trust you and yours will successfully navigate this financial mess perpetrated by the CROOKED Pols and Investment Bankers. Dem need some good jail time or a taste of the Cat-o-nine!

  10. Does the Minister of Finance need to take another look at the budget, which was likely completed before last Friday?

    • Does the Prime Minister need to appoint a Chief Justice yesterday given the rising perception that crime is ramping up?

  11. “Well PDC I have no pretensions to having a crystal ball, and I fully expect some proportion of my opinions to be shown to be incorrect.

    PDC might want to note that credit ratings relate to debt instruments and not to stocks.

    Interestingly while stock markets are falling, the very instruments that were downgraded, US government debt are rallying to date. We saw a similar thing happen when Japanese debt was downgraded from AAA as well. ” Dr. Justin Robinson in an earlier post today.

    There are several reasons why the values of traded stock on many stock markets across the world are tumbling. One of these reasons is that the cost of the US government’s borrowing will go up upon the Standard and Poor’s downgrade of the US Government debt profile.

    This type of action will make interest rates higher for the US Government when it borrows money. This in turn will make the recoveries in the US economy and in some other economies less certain esp. when they are other indicators that the US economy and those other economies are not doing well ( Eurozone countries’ debt crises – which are producing their own contagion effects).

    So, many stock investors fearing a worsening of the US economy and those other economies will necessarily seek to sell their stocks for income – which they will seek to place in what they believe are safer monetised assets – some of which will include US 10-year and 30-year treasuries and some other governments of this world treasuries.

    So, the many stock market values are tumbling for different reasons than the fundamental reason why these US treasuries are advancing – albeit that their yields are declining.

    So, Dr. Robinson, the fundamental reason must be that which relates to why there was an eventual increase in the US Government debt ceiling – THE POWER BEHIND THE US GOVERNMENT’S BID TO AVOID DEFAULT ON ITS DEBT COMMITMENTS AT ALL COSTS – THE BID TO MAINTAIN THE SAFENESS OF THESE SECURITIES IN TIMES OF POLITICAL ECONOMIC UNCERTAINTY DISTRESS ( US treasuries rise too when times are getting better economically).

    What the Goodly Doctor must tell BU readers is that long before the Standard and Poor’s downgrade of the US Government debt profile, US Government treasuries were on a long term upward path (!!!!


  12. Everyone is waiting on what the Bernanke has to say/not say this morning. My mentor, was an econmics advisor to the leader of a powerful, western nation, in the 80’s…. 😀

    Sorry, I cant say more.

    Silver is always a violent ride in these conditions, for now it is being capped by jpm manipulation, via the gold ramp up to cover their short position….Which means to keep this going, they have to take out Bank of America….. amazing to watch these vampires operate. The hit is out on the BOA.

  13. I don’t pretend to understand why the stock market moves. I tend to think the stockmarket is dominated by sentiment. In fact two sentiments, fear and greed. Fear seems to be ruling right now.

    The most common explanation given for the recent drop is the growing expectation that the USA and the world economy will fall back into recession. The recent slew of economic reports contributed to this view and the downgrade certainly dealt something of a final blow to investor confidence.

    PDC I don’ t think debate should be about scoring points or who is right or wrong. I would want to point out what I think kinda got lost in the focus on the stock market declines. That is, the very investments that were downgraded, were the ones investors flocked to yesterday. US Treasuries increased in value yesterday as fear stricken investors fled from stocks and sought the “safe haven” of US government debt. As I said one trading day does not a trend make lets see what unfolds over the week. People like money brain are probably looking for the new buying opportunities.

    By the way when are the Credit Unions going to offer mutual funds as the next stage in their development as truly empowering, indigenous financial institutions? I thimk I see some potential fund managers on this blog.

  14. Dr. Justin Robnson,

    We think you know that the credit ratings issued by Standard and Poor’s, and based on their assessments, in this case, of governments debt profiles across the world, are NOT any government securities or by extension stock MARKET analyses or opinions, and therefore are and can NEVER be intended to be such, or substitutes for such, even though they can influence such stock/security market behaviour.

    Therefore, it would not be difficult for you to understand that in making these assessments Standard and Poor’s is not a stock market broker, or substituting for such, or having that type of relationship with others – IT IS A CREDIT RATING AGENCY.

    So, we are mindful of such when Standard and Poor’s wrote: “The downgrade REFLECTS our opinion that the fiscal consolidation plan that Congress and the Administration recently agreed to falls short of what, in our view, would be necessary to stabilize the government’s medium-term DEBT dynamics.

    “More broadly, the downgrade REFLECTS our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges to a degree more than we envisioned when we ASSIGNED a negative OUTLOOK to the rating on April 18, 2011.

    “Since then, we have changed OUR VIEW of the difficulties in bridging the gulf between the political parties over fiscal policy, which makes us pessimistic about the capacity of Congress and the Administration to be able to leverage their agreement this week into a broader fiscal consolidation plan that stabilizes the government’s DEBT dynamics any time soon.” Taken from

    (Capitals our emphases)

    As for credit unions’ development in Barbados they are wrong to be following a type of development like the banks have. (Mutual Funds now???)

    At the end of the day they and their memberships are going to loose out significantly developmentally.

    Practically speaking they are going to be developing the personal commercial affairs of others more than they themselves and their members.


  15. The US Central Bank has made its first move since the downgrade. In effect they have moved to lower interest rates across the economy.

    This is a detailed piece on Bloomberg.

    Aug. 9 (Bloomberg) –Treasury two-year notes rose, pushing yields to a record low, after Federal Reserve officials said economic growth is “considerably slower” and the Treasury’s sale of $32 billion in three-year notes drew stronger-than-average demand in the first note sale since Standard & Poor’s cut the U.S. debt rating Aug. 5.

    Yields on 10-year notes erased gains as policy makers left their target interest rate in a range of zero to 0.25 percent and pledged to keep it there through mid-2013. The Federal Open Market Committee discussed a range of policy tools to bolster the economy and said it is “prepared to employ these tools as appropriate,” it said in a statement today in Washington. The notes drew a yield of 0.50 percent, a record low at auction. The bid-to-cover ratio, a gauge of demand was 3.29, compared with an average of 3.15 for the past 10 sales.

    “It’s pretty amazing that the Fed will be exceptionally low until 2013,” said Jason Rogan, director of U.S. government trading at Guggenheim Partners LLC, a New York-based brokerage for institutional investors. “They are telling you that we are in a stage of Japanese-like growth. The front end is rallying like crazy.”

    Yields on two-year notes fell 10 basis points, or 0.10 percentage point, to 0.17 percent at 2:42 p.m. in New York, according to Bloomberg Bond Trader prices. The 0.325 percent securities maturing in July 2013 rose 6/32, or $1.88 per $1,000 face amount, to 100 13/32. The yield reached 0.1568 percent, lower than the previous record of 0.2283 percent yesterday.

    Thirty-year bond yields rose six basis point to 3.71 percent. Benchmark 10-year yields fell two basis points to 2.30 percent.
    Bid Pattern

    The three-year note auction drew a yield of 0.50 percent, the lowest yield since records began in May 1981. It was less than the 0.523 percent average in a Bloomberg News survey of seven of the Fed’s primary dealers.

    Indirect bidders, an investor class that includes foreign central banks, purchased 47.9 percent of the notes, the most since May 2010, compared with an average of 33.9 percent for the past 10 sales.

    Direct bidders, non-primary-dealer investors that place their bids directly with the Treasury, purchased 11.1 percent of the notes at the sale, compared with an average of 13.2 percent for the past 10 auctions.

    At the July sale, the securities drew a yield of 0.67 percent.

    The offering is the first of three note and bond auctions this week totaling $72 billion. The Treasury is scheduled to sell $24 billion in 10-year debt tomorrow and $16 billion of 30 year bonds on Aug. 11.
    Market Surge

    Treasuries surged yesterday as tumbling stock markets sparked demand for the safety of government debt. S&P cut the U.S. government’s AAA credit rating at the end of last week, while Moody’s Investors Service and Fitch Ratings have affirmed the U.S. at the top rating.

    Volatility in the Treasury market has picked up. Merrill Lynch & Co.’s MOVE index, which measure price swings in Treasuries based on prices of over-the-counter options maturing in two to 30 years, rose yesterday to 117.8, the highest since Dec. 17, up from a 2011 low of 71.5 in May.

    The 10-year note yields dropped earlier today to 2.27 percent, the lowest level since January 2009. The extra yield investors get for holding 30-year bonds instead of two-year notes was 3.41 percentage points, almost the narrowest on a closing basis since October 2010.

    Treasuries have returned 6.2 percent this year, according to indexes complied by Bloomberg and the European Federation of Financial Analysts Societies. Japan’s government bonds have gained 1.3 percent, while German bunds have returned 4.8 percent, the indexes show.

  16. @Dr JR
    Sentiment is very important without doubt, from my experience, especially at extremes. I advised both my children to minor in Psych in their Business degree, you must understand how humans and your own mind works.
    How else can you explain why stock markets tend to outperform in lower growth decades and underperform in high growth decades.?

  17. @Moneybrain

    In an earlier post you were touting the value of gold as an investment, does that include both bullion and equities? If it is the latter what did you tell your clients when Michael de Guzman allegedly walked out of a helicopter over the jungle in Indonesia without a parachute?


    S&P Futures 1,170.00 +60.00 +5.41%
    Nasdaq Futures 2,155.00 +119.00 +5.84%
    Dow Futures 11,185.00 +450.00 +4.19%

    Bonds & Currencies
    10 Year Yield 2.18% -0.16 —
    1 Euro $1.4383 -0.0009 -0.0622

    Oil $82.26 +2.96 +3.73%
    Gold $1,756.70 +13.70


    S&P Futures 1,169.50 -2.20 -0.19%
    Nasdaq Futures 2,153.50 -1.50 -0.07%
    Dow Futures 11,158.00 -36.00 -0.32%

    Bonds & Currencies
    10 Year Yield 2.18% -0.16 —
    1 Euro $1.4382 -0.0010 -0.0705

    Oil $82.28 +2.98 +3.76%
    Gold $1,755.80 +12.80 +0.73%

  20. @Sarge
    I would strongly urge investors to be very circumspect when it comes to speculating in individual gold/ precious metals stocks. I never recommended or even accepted client instructions to purchase Bre-X. Please note that the definition of a gold mine is “a hole in the ground with a liar on top”

    My research had strongly shown that there was/ is a secular cycle where stocks perform for 15-20 yrs( approx 17 normally) and concurrently commodities/ precious metals underperform badly, in this case 1981-1999.
    So in 2000 it was time to sell stocks and wait for the comm/ gold cycle to start cooking. I initiated gold positions in Feb 2002 and my clients are sporting 850%+ gains BUT in Gold stock mutual funds where any Bre-X clones would cost only 2-3%. Now we have Gold Bullion funds which are somewhat less volatile.

  21. @Alien
    Americans are the dumbest white people on Earth! If you want proof the average American has 7 credit cards and the avg German 2. I like it this way because it is easier for me to make money and live a sweeter life. I dont like it that their leaders permit the nonsense that goes on eg poor
    education, health care, spending on prisons not improvement etc.

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