Risk and Sovereign Debt
Upon further review, S&P's downgrade of the United States bond rating . . . still makes no sense.
With everyone from Paul Krugman to yours truly castigating Standard & Poor’s for the logic behind their downgrading of the US bond rating, Felix Salmon valiantly steps in to defend them:
[T]o understand S&P’s actions, you just need to understand two basic facts. The first is that S&P is not judging the quality of Treasury bonds as an investment. There’s a key difference between S&P, on the one hand, and Moody’s, on the other: when rating sovereigns, S&P doesn’t care about or look at the likely recovery in the event of default. If the US ever did default, investors would ultimately get back 100 cents on the dollar, interest included. Shorting Treasury bonds into that kind of a default wouldn’t make you much money. But it would still be a default — and S&P is trying to gauge the likelihood of such a thing happening.
Secondly, and more importantly, all sovereign defaults are political, not economic — especially defaults by countries which borrow exclusively in their own currency. S&P and Moody’s can look at all the econometric ratios they like, but ultimately sovereign ratings are always going to be a judgment as to the amount of political capital that a government is willing and able to spend in the service of its bonded obligations. If Treasury really believes that S&P based its judgment fundamentally on debt ratios and the like, it’s making a basic category error about what it is that sovereign raters actually do.
Well . . . okay. But that’s not how investors actually use the ratings. Companies tie investment decisions to these ratings precisely because they’re institutionalized measures of risk. If getting the promised return on investment is a certainty, there’s no risk.
But even if we accept Salmon’s and S&P’s logic, if it makes sense to downgrade the US because of our undeniably messy politics and an unwillingness by one of our two political parties to raise taxes, surely that same logic could be applied to other countries S&P still rates AAA? Noah Millman:
[T]he United States has the strongest credit in the world, as evidenced by the extraordinarily low rates of interest demanded for our debt and by the fact that when there is a financial crisis – even one caused by purported fears of an American default! – investors flee to the safety of . . . American government debt.
You say, apropos of the recent game of chicken between the GOPand the Democrats, that American political institutions have proven themselves to be significantly flawed, unable to deal with serious fiscal challenges. What, praytell, do you think of the vastly more significant game of chicken playing out across the pond between Germany and the more economically troubled members of the Euro zone (particularly Italy)? Why should Germany still be rated AAAwhen it doesn’t even borrow in its own currency, and faces the potential collapse of its entire banking system if an adequate solution to the Euro crisis is not found?
(Note that I don’t expect any such thing to happen. But I also don’t expect the United States ever to default on its debts. My point is that if I had to compare the likelihood of the collapse of the Euro versus the likelihood of an American default, why on earth – even in the wake of the recent absurdity – would I rate American default more likely?)
Indeed, many very smart analysts think the collapse of the Euro is a strong possibility. As screwed up as Washington politics is, we’re pikers compared to Brussels. At the end of the day, the United States remains a single country. The EU is a loose confederation of 27 sovereign states, of which the Eurozone is a 17-state subsection.
I think it is only a matter of time until the EU countries on the list get downgraded. I see no way out of their problems. Once the defaults start, their big banks will be insolvent. However, to date, they have not had a very public near default just because of their political process. IOW, while the EU’s economics are worse, their politics has not gotten as bad as ours, yet. Other countries on their AAA list, like Canada, probably deserve to be there. (BTW, this would be a good time to read Reinhart and Rogoff’s book if you have not done so yet.)
Steve
S&P doesn’t do objective risk assessment. It’s a lobbying firm that gives the ratings it is paid to give. They’re economic hitmen for hire, and they’ve been paid to lobby for austerity and privatization. There is no empirical basis for taking anything it says seriously.
I like Salmon, and argued pretty much the same position yesterday.
Yes, exactly. That is probably the European fear, as I mention in another thread, at this very moment.
But backing up a bit, you say “that’s not how investors actually use the ratings.”
Beware, it is much more complicated than you might think. The Chinese, for instance, have publicly stated that they don’t trust the US ratings agencies, and use their own analysis.
Note also that the Chinese complaint was that the big three were slow to downgrade western sovereign bonds from AAA.
A wise decision.
It looks like S&P puts Japanese bonds at AA-, Italian bonds at AA-, US bonds at AA+, and French, German, and UK bonds at AAA. Currently.
Note that the AA- did not destroy Japan, and did not elevate their borrowing rates.
The simple story of how bond rates and borrowing costs relate is just that … a simplification.
@john personna: No one in the bond market trusts the ratings agencies. That’s been the greatest loss of the economic crash: loss of trust to widespread fraud and overly complex financial products desgned to confuse
suckersclients. I’m beginning to agree with James Galbraith that trust can’t be restored in the existing system, that things are too far gone.@Ben Wolf:
I guess Ben, that I am arguing a middle position between James’ and yours.
James is using the framework that ratings agencies are integral and trusted. You are saying that they are completely over and superfluous. Isn’t it pretty clear that we are in a middle ground?
Actually, I can argue that from a “crowd psychology” view. The ratings, even if they lag, and only represent what investors already know, are still a feedback system. They still pump out the news, from the insiders who actually buy the bonds to … people like James, who are a little shocked to see the AAA go.
(Perhaps that I don’t trust ratings agencies is what makes me more open to their upgrades and downgrades. I take them as part of the news flow. I literally do take ratings as a notation of what The Street already thinks. And then keep reading.)
@john personna: Yes, I gather that is precisely the European fear. Whereas our reaction to this has mostly been “WTF?” there’s has been “Who the hell do these ratings agencies think they are?”
@James Joyner:
Heh, yes. I think a lot of it is that even as people recognized all the dysfunction in the budget and debt process, they also thought that “hey, we are the U.S.A., we get AAA for-evar!”
The Chinese ratings agency, Dagong, has cut its rating of U. S. public debt from A+ to A. That’s the same level as it rates Estonia. Since it’s state-owned I think that’s probably the official position. My interpretation of this rating as well as S&P’s is that it’s a move in a campaign to raise the risk premium on U. S. public debt.
IMO the harsh criticisms of S&P for the move are misplaced. It wasn’t all that long ago that we were criticizing S&P for giving AAA ratings to instruments that clearly in hindsight weren’t AAA. There’s obviously been too much grade inflation. IIRC there are only four companies that have AAA credit ratings. Suggests to me that most of the countries that have had AAA ratings, including the U. S., don’t deserve them.
@Dave Schuler:
Good for me, bad for the Treasury.
I had posted this on another thread, but I think it’s worth repeating here. Clive Crook had a rather interesting analysis of the downgrade:
http://www.theatlantic.com/business/archive/2011/08/some-thoughts-on-the-s-p-downgrade/243209/
In particular, he notes that one of the biggest concerns that he sees is, post agreement, the general “Democratic” pundit consensus was that their problem in the negotiations was that they were not willing to go into default. His concern is that this could — in a future crisis — actually lead to a complete failure to reach agreement if the Republicans run a similar strategy (or fail to find consensus within their party).
In other words, what happens if both parties opt for the “Kamikaze” strategy?
@Dave Schuler:
I disagree. Look at how the S&P down grade went. There is a timeline here: http://www.businessinsider.com/the-story-behind-sps-downgrade-2011-8
S&P presents it case for the down grade, it is then told that its numbers are wrong, it is stunned by the error, double checks with the CBO and finds that yes, in fact, they dont know how the CBO scores budgets. They then change their rational for the downgrade and do it anyway.
That is a bad move for anyone. When you make a major mistake like that, you have to take some time before you go ahead and pull the trigger. You have to at least look like you are re-evaluating the new data.
But that is not the biggest mistake with S&P.
Think about that for a minute. A company whose main job is to rate debt risk and does so for
sovereign debt world wide, does NOT KNOW HOW THE LARGEST SOVEREIGN DEBT ISSUER IN THE WORLD SCORES BUDGETS!
Regardless of the rather S&P was right or wrong, they wont survive this and they should not. They are as incompetent on this as they were on Lehman. Now the spotlight will be shined very brightly on how they determine debt ratings. And with their history, it wont be pretty.
@mattb:
I’d heard that position argued, that the Dems should have played chicken, harder. Joe Scarborough tried that one … though I’m not sure he totally believed it.
In the end I think it was a weak criticism of Obama centrism. Obama really did have the adult position, and arguments that we would have been safer if he’d been less reasonable fall flat.
@Jib:
Are you saying S&P should take the issuer’s word? Wasn’t that the 2008 problem? And not the solution?
Good analysis from James Kwak: So What? Part Two
Heh.
@john personna:
How the CBO scores the budget is the accounting, the books for the US govt.
This is not a he said, she said, situation. There is no “They said X but we dont believe them”. S&P admits they made the math error. They got it wrong, period. It was a flat out mistake.
Maybe if they had taken some time after they found the error, delayed the announcement, they could have come up with something like disagreeing with the CBO.
That would be a huge deal by the way. As every one knows, the govt does not keep its books like any corporation. If the rating agencies start requiring that they do, that would be a game changer.
But they did not do that. I dont understand why they had to rush it out. What is the big deal about Aug 6 instead of Sept 6 to make the announcement?
I am sure that question will be asked during the investigations.
Just to be clear, I think there is a real case to be made for downgrading the US govt debt. I just dont think S&P has the standing to make that case. They have made too many major errors in debt rating over the yrear. They dont have the status to be taken seriously on this. In short, they should be out of the debt rating biz.
@john personna: I largely agree. Which is why I think there is also a lot of truth in aspects of Glenn Greenwalt’s analysis of Obama’s bargaining.
On a related note, I think it has been interesting to see how many Dems and pundits (independent and on the left) who talk about the importance of “compromise” in these dealings and then immediately work to assign winners and losers (vacating compromise and taking everything back to a zero sum game).
@Jib:
I don’t think $2T over 10 years is our real problem right now. Our real problem is that congress cannot directly tackle tax and spending levels. They are still trying to shield themselves with committees … despite having tried and failed with the committee process in the past.
You know, a good topic for an article and thread would be “what would it take to get AAA back?” That’s a better way to look at it, IMO, than “oh noes, we deserve AAA anyway.” (I know that you see the case for a downgrade, but I think this is the general zeitgeist.)
@Jib:
Who made the CBO the god of budget scoring? It’s a long time complaint that the CBO routinely uses overly optimistic economic assumptions in order to make things come out right. For example, they always assume that starting next year, the AMT is going to return full force and stay forever, even though anyone with half a brain knows congress is going to continue to pass the “AMT Fix” every year. Likewise with the “Medircare Fix”.
A legtimate alternate choice of economic model for predicting future performance is not and error, it’s a disagreement. This is just another round of the standard “All reasonable experts agree….” that Obama loves to use to suggest that anyone who disagrees with his predictions is being disingenuous.
@Stormy Dragon:
Congress, the executive branch, the courts, and most importantly for you, the FREE MARKET has made CBO the god of budget scoring.
Again, S&P does NOT dispute the error.
They certainly could have changed their rational to say ‘We disagree with the CBO’ but they did not.
I understand why this is hard to grasp. How in the world can an ‘expert’ in rating sovereign debt not understand how the accounting of sovereign debt works? That cant be right, it has to be a disagreement, a political fight, Obama’s fault, etc, etc. Come on, to believe that they made this basic mistake is to say that S&P at a fundamental level does not understand its job. That cant be true!
But it is, and there is plenty of history of back this up. Just look at all the blown calls leading up to 2008. S&P does not know what it is doing.
@john personna:
I agree. I dont know if the US should be AAA or not. We own the printing presses for the debt that we issue so there is 0 chance the US will default. What can happen is inflation that will reduce the value of the money that will pay off the debt. Clearly the Fed would love to get inflation going but so far they have had a hard time doing it.
We all see the weakness, we see why you would say the US is not in as good of shape as it has been. But at the same time, we dont really have the really big issues that the EU and Japan has.
We spend 25% of GDP, we tax 15% of GDP. The difference, 10% of GDP is the deficit. It is unsustainable in the long term, and probably the mid-term. But 25% of GDP in spending is not terribly high. We could do the whole thing with taxes. At 25% of GDP we would still be one of the smaller govts in terms of spending as a % of GDP in the first world. And at 25%, one of the lower taxed.
Not that we want to do that but we have plenty of options, unlike most of the European countries or Japan. Looking at the whole world, we are not in that bad of shape.
@Jib:
S&P’s response was more, “It’s completely irrelevant to our results, so if it’s that important to you, we’ll use your numbers. But pay attention, because you’re missing the point here.”
@Stormy Dragon:
Hmmm, its completely irrelevant to there point uh? Then why was it the reason they themselves gave for the downgrade?
Only when busted did they say “Oh math is hard, it doesnt matter, you know what I mean!”
This is S&P. It is a big deal that they cant do the math.
@Jib:
Their point was that once you factor in future obligations, our long term deficit is $211 trillion and that we lack the political will and ability to do anything about it. The fact the Treasury department wants to have an argument over whether it’s $211 trillion or $209 trillion is completely irrelevant to that issue.
@Stormy Dragon:
Future obligations are not debt. It is not debt until the check is cut and the bond is sold to cover the check.
I think the future obligations argument is way overblown. If something cant be done, it wont be done. If we can not meet those obligations, we wont pay them. Period. Since we wont pay them, there will be no debt issued to pay them.
It is a default if you do not pay off debt. It is not a default if you cut SS benefits.
Will it be pleasant process cutting back our obligations? No, but it will happen.
And why is this a problem now? SS has years to go before it is a problem. How can anyone really know what the economy or the political environment is 10 years from now much less when SS becomes a real issue.
If there argument is resting on long term issues with SS then it is weaker than even I think it is.
@Jib:
Uh yeah, try running a company on that theory sometime and see how the first audit goes. Although this is, oddly enough, the way the US government routinely figures things, everyone else is required to account for their long term liabilities.
Brodsky & Quaintance have what I think is a good take on all this. http://www.ritholtz.com/blog/2011/08/sp-downgrade/
Basically if this is about the US debt then the downgrade is bogus. There is 0 chance the US debt will not be paid. However if this is really about the value of the dollar when that debt is re-paid, that is that the debt will be repaid with devalued dollars, then it is a legitimate downgrade.
However if it is about the dollar and not the debt, then the downgrade is incomplete. If the downgrade is because S&P thinks the dollar is going to be devalued then NO dollar denominated debt should be AAA. No corporate, no state, no muni, none.
I think they are right. If the Fed is not AAA then no dollar denominated debt is AAA. It will be interesting how the markets price all dollar debt after this.