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Raul Elizalde - Thursday, April 21 2011
It’s official: the United States may no longer be “risk free.”
Standard & Poors (S&P), a company that makes a living by rating countries’ and companies’ obligations, this week issued a warning – at no charge – that the credit rating of the United States faces a “negative outlook.” Does this matter?
S&P is not the only company that rates sovereign credits. Moody’s is the other big one, and Fitch, a smaller agency, is a distant third. The three are known as Nationally Recognized Statistical Rating Organizations (NRSROs), and are the best known among the ten agencies the SEC recognizes.
Credit ratings generally matter because they are entrenched in regulations and investment policies. For instance, bank regulatory rules measure the quality of banks in part by the average credit rating of their securities holdings. In some cases, investments in certain classes of securities are prohibited until the securities achieve a certain rating.
The same goes for investment companies: a mutual fund, for example, may have to drop a bond that has had a rating downgrade, or may be able to buy a bond that has been upgraded. Securities with a lower rating may also be less desirable collateral for a loan, or may be less marginable. Ratings, therefore, directly affect the price of a security and the price an issuer has to pay in order to raise money.
The United States has long been held as the standard of creditworthiness. In academic literature, US Treasury obligations have been defined as “risk free” securities (that is, free from the risk of default). That’s why all other interest rates measured in US dollar terms are expressed in terms of the “spread” over US Treasuries: no other entity can borrow at a cheaper rate.
With this background, one would have expected S&P’s announcement to be earth-shattering. But it wasn’t.
Part of the reason is that a “negative outlook” does not carry as much urgency as a “review.” Another reason is that S&P acted alone.
In 1996 Moody’s put the US in review for possible downgrade, a much more serious move than a mere negative outlook, after Congress refused to vote to increase the debt ceiling. Last February, Moody’s warned that the same thing could happen this year if the debt ceiling was not raised. However, the senior US analyst for Moody’s also said that an actual rating change would only be considered if the US were to actually miss a debt payment. In fact, he stated, there would be a chance that the rating would not be cut at all if the missed payment was made promptly after the due date, even if it was late. So after those comments, Moody’s didn’t even bother to cut the US outlook and left it at “stable.”
So why did S&P change the outlook? It specifically mentioned the risk that policymakers would not agree on how to address the country’s budget problems by 2013. A closer look suggests that this may be an odd reason to change a sovereign outlook. An IMF study from October 2010* shows that political risks come after public finance, debt, growth, and external finance when it comes to downgrade a country’s outlook (see graph below). S&P mentioned some of these risks but boiled it all down to politics. The difficult political environment, it seems, is the biggest problem the United States faces to get its house in order.
Does the change even matter? The same IMF study shows that no sovereign rated above BB+ (10 notches below AAA) defaulted in the last 35 years, suggesting that even if the US was downgraded, the chance of default would still be essentially zero.
Nevertheless, because of the technical aspects of how credit ratings affect supply and demand, one might expect that a credit watch would have an impact on the price of US obligations. Yet, US government bonds and the US dollar went up, not down, in the wake of the announcement.
The whole episode seemed a bit of a waste of everybody’s time at best, or a publicity stunt at worst. As a sovereign assessment it did not offer any new information on the creditworthiness of the United States. As a warning to US policy makers, it actually provided them with ammunition to further entrench their positions. Markets, except for a short-lived stock market dip, were unimpressed.
There is no doubt that policymaking in Washington is going through a badly contentious period, just at a time when solid governance is most needed. The fact that problems today are larger than any we have encountered in more than a generation is surely a big reason why it has become so difficult to agree on how to solve them.
Yet, S&P’s unsolicited review did not say anything we didn't know already. Ironically, it might hurt S&P more than it might hurt the standing of US credit quality. To this observer, S&P gave the impression that it just wants to show it matters, and that even though or perhaps because it badly misjudged the credit quality of mortgage-backed securities in the late 2000s, it is now determined to be more alert.
The fact remains, however, that the poor job S&P and other credit rating agencies did at rating complex instruments they didn’t understand contributed greatly to the financial crisis that ensued, and this week's move does nothing to enhance their reputation. Back then they proved that they were dangerous. This week they showed that they can also be annoying.
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*“Uses and Abuses of Sovereign Credit Ratings”, John Kiff, IMF, October 19 2010.
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We use quantitative measures to build and maintain portfolios for our clients, which we rebalance every quarter. We described our investment process in previous newsletters. If you would like to know more about how Path Financial’s investment process works, call us or send us an e-mail at the address below. We’ll be happy to set up a confidential meeting to discuss new paths to financial success.
Raul Elizalde | raul@pathfinancial.net | 941-350-7904
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