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.
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