Be-Ratings Wars

August 30th, 2011
by Jonathan Leidy

With several weeks in the rearview mirror since Standard & Poor’s historic downgrade of the United States’ credit rating, it is worth a look back to process everything that has transpired.

Beginning with the obvious, the downgrade caused the global markets to go berserk, producing a multitude of indisputably outsized numbers:

  • The Dow Jones Industrial Average experienced an unprecedented 4 consecutive trading days during which the index moved by 400 points or more, in  either direction.
  • Volatility exploded, with August futures on the VIX (the market’s volatility index) trading at a record 100,000+ contracts/day for 3 days in a row
  • Gold hit a nominal high of greater than $1,800/troy oz., and is only a karat or two away from its inflation-adjusted high of ~$2,250/troy oz., established in 1980

S&P’s US downgrade was an unmistakable watershed event, causing everyone from the President to the proletariat to take a long, hard look at the lackluster numbers that have typified the US economy for months. Perhaps equally noteworthy during the tumult, however, was the sheer quantity of contradictions, ironies, and paradoxes that arose throughout the downgrade process. They sprung from all sides, ranging from the subtle to the downright staggering, and yielded a portrait of a country desperate for direction. What follows is a chronicle of these incongruities.

Congress Holds the Country Hostage

The debt ceiling debate, and the bitter backbiting that followed, has received mountains of coverage. However, it warrants reiterating that the entire debate centered on Congress’s unwillingness to authorize revenue generation, i.e. bond issuance, to cover debts that they had already approved a mere 3 months prior during the 2011 fiscal budgeting process.

If Congress had objections about the amount of debt that the country was incurring, then how could they, in good conscious, pass the budget? And if the budget did indeed pass muster, it must have been with the understanding that there was not enough revenues to support it. So how then could Congress contemplate welching when it came time to cover the shortfall? This sort of flagrant disregard for fiscal integrity, calls into question the very purpose and validity of the budgeting process itself… not to mention the ensuing debt ceiling debate.

A Ricochet Across the Bow

S&P’s downgrade of the US marked the first time in history where the sanctity of the county’s credit rating was legitimately called into question. In doing so, S&P expressed their mounting concern about the US’s ability to make good on their existing debts and projected future liabilities. Of course there is the palpable irony that S&P, one of the handful of ratings agencies that played a major role in the ’08 credit crisis, was now passing judgment upon the world’s most liquid “super credit.” However, using S&P’s historical failures against it, as the administration subsequently attempted to do, is equally amusing. How can S&P continue to do business, if every time they contemplate a credit change, their past is used to discredit their current judgment? Said differently, should S&P continue to do a lousy job rating credits just because they have done so in the recent past?

Cooling Off Turns Up the Heat

Heaping a few more irony logs onto the fire, S&P suggested that their rationale for waiting until the afternoon on Friday, August 5th, to announce the downgrade was so that markets would have the weekend to digest the news. In truth, markets cannot do much over the weekend, let alone process the unprecedented violation of one of the few believed-to-be immutable laws of financial physics. Instead of offering the information directly to market participants, S&P offered it first to the media for a frenzy-filled weekend of joyriding. On Monday, the 8th, the stock market opened down more than 5%. Retrospectively, it appears that slathering a weekend’s worth of headline risk on top of what was already a healthy helping of uncertainty wasn’t exactly the Pepto the market needed.

The Great Discounter Gets Discounted

The stock market is universally viewed as a leading indicator, where securities prices move well in advance of information and the actual economy. So when S&P began telegraphing the possibility of a US downgrade, traders and talking heads alike decried the alleged negative effects it might have on the market. Price stability in the weeks leading up to the debt ceiling showdown was used as evidenced that “The Street” was coolly indifferent to S&P’s opinions. “They aren’t telling us anything the market doesn’t already know,” was the deafening refrain.  Yet shortly thereafter so were investors’ cries of “uncle” as the market dropped precipitously following S&P’s announcement, directly calling into question what the market really “already knew.”

AA+ Becomes the New AAA

S&P’s downgrade of the US, formerly one of the world’s few AAA-rated credits, suggests the need for a whole slew of additional “recalibrations.” To S&P’s credit, they have at least marginally attempted to follow the downgrade chain to its logical terminus. After the US’s ignominious peg-knocking, S&P downgraded a host of banks and credit instruments that were heavily dependent upon US bonds for either collateral or prefunding.

But where does it end… or begin, for that matter? Are France and the UK still AAA credits given all of their structural challenges? Both countries have lagged US GDP growth for decades. Or is it any more plausible that the US is only a marginally better credit than Abu Dhabi or Estonia? Similarly, what was the threshold for debt to GDP that finally got S&P thinking… 100%? Either the US is a credit that should have been downgraded years ago, as debts were beginning to snowball, or nothing has dramatically changed about the nation’s ability and willingness to pay its debt… not both.

Pop Goes the Default

The bond market certainly disagreed with S&P. Following the US downgrade, equities tumbled, sending investors flocking for… wait for it… US Treasuries. In perhaps the most ironic turn of events in this whole imbroglio, 10-year treasury prices skyrocketed, driving yields to all-time lows and undercutting yield spreads for the remaining AAA-rated nations. Hence another paradox formed whereby the very borrower that S&P maligned actually became the debtor of choice. By this logic, S&P could continue to cut the US’s credit rating to deep junk status, which would in turn drive bond prices up even further, take rates straight through zero, and investors would eventually be paying the Treasury to hold its “junk” debt. Equally ridiculous (and ironic, of course) is the idea that investors, while flocking to Treasuries, engaged in the wholesale dumping of companies with far superior balance sheets than the US itself.

What’s a 13-Figure Error Among Friends?

Prior to the downgrade, S&P stated that any debt ceiling deal that was not accompanied by at least $4T in cuts would likely precipitate action on their part. The debt deal that ultimately passed, engendering only $2.4T in cuts, lead S&P to make good on its word. Yet less than 48 hours later it was revealed that S&P had made a serious “rounding error” by overestimating the US’s future deficit by roughly $2T. This miscue, not only fully debunked their mathematical rationale for the downgrade, but it also reinforced the jaundice with which S&P was being regarded as a result of their 2008 failings. When questioned as to how they could continue to maintain their downgrade given their enormous error, S&P quickly turned to political gridlock as the “new” primary driver behind the move. And it gets better… the entity responsible for unearthing the error… the US Treasury. The message is clear; the Treasury may be fiscally challenged, but at least they can add.

No Defaults Here

The fact remains that the US Treasury, despite all of the country’s current challenges, is still the most liquid government debt security in the world. Before the US would ever opt to default on its debt service, it would fire up the printing press and reel off sheet after sheet of ever-depreciating greenbacks.

Moreover, S&P’s revised rationale for the downgrade, i.e. political infighting, as thoroughly odious as it has been, is not even a criterion for downgrade within their own ratings algorithm. According to their most recent publication on sovereign credit evaluation, S&P ratings covers a “sovereign’s ability and willingness to service financial obligations to nonofficial, in other words commercial, creditors.”

The US’s ability to pay its debts, even if predicated on currency debasement, is unquestionable. In terms of willingness, the debt ceiling had already been raised prior to the downgrade. So in yet another contradiction, as soon as the US fully complied with S&P’s ratings criteria, they were downgraded. In addition, S&P’s methodology only applies to “commercial,” i.e. non-sovereign creditors. Given that more than 30% of US debt is held by other sovereigns, the US’s ability/willingness to meet its obligations, by S&P standards, is even less in question.

Congress Confirms S&P’s Worst Fears

As irony-laden as this entire scenario has been, there is more. For when S&P was forced to restate their reasoning for the US downgrade from fiscal to political, Congress proceeded to validate that very argument. In addition to all of the floundering and finger pointing that seems to be the hallmark of recent political responses to fiscal crises, Congress upped the ante with the creation of the “Super Committee.” According to the LA Times, as of Friday, August 18th, the committee had “extraordinary new power to cut the deficit, but so far no meeting room, no staff director, no clear rules and no signs of compromise by either party.” When the dust finally settles on the Super Committee, it stands to reason that the only thing that will have been “super” about it will be the amount of time and money it wasted… just the sort of thing that S&P was deriding in the first, well actually second, place. 

The Other Ratings Agencies Hold Firm

Moody’s and Fitch, the other major ratings agencies, opted to leave S&P on the bleeding edge by holding fast on their assessment of US’s credit rating. The President and both aisles of Congress, presumably attempting to restore confidence, lauded the stalwart credit agencies for not succumbing to the pressure created by S&P’s lead. As previously noted, the government and the media concurrently lashed out at Standard and Poor’s, calling into question their abilities in light of their not so distant shortcomings. However, weren’t there a couple other credit rating agencies that experienced equally monolithic meltdowns in their algorithms during the credit crisis?  Hmmm.

Further, both Moody’s and Fitch pointed to the same mounting debt issues and political intransigencies observed by S&P as causes for a possible US downgrade in the near-term. So in point of fact, their determinations were only marginally different than the one being trounced by pundits.

S&P: The US’s Closet Savior?

Despite all of the backlash and bad math that S&P has created over the past few weeks, their forcing of the US’s hand in the longer-term fiscal austerity debate may one day be regarded as move of epic significance.  Up until now, America has blithely traipsed along, while bloated entitlement and defense spending has blown right through tenable.  A wake up call was long overdue.  So will it matter 5 or 10 years from now that the bucket used to douse the sleeping populous was actually more of a sieve?  Probably not… but it will be quite ironic.

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