Last Wednesday, the investment rating firm Moody’s put United States bonds on a “downgrade watch” list because of the unresolved debt ceiling debate. Moody’s made clear that any default, no matter how brief, would “fundamentally alter the agency’s assessment of the timeliness of future payments, and that the Aaa rating would likely no longer be appropriate.” Not to be outdone, Standard & Poor’s also placed the U.S. on credit watch and warned of a 50-50 chance of a downgrade from the highest rating of AAA to AA. These dire pronouncements put the whole investment world into a tizzy. What is the significance of these statements, and what has changed as a result?
The Rise and Fall of Rating Agencies
Moody’s and Standard & Poor’s are the most prominent firms that rate investments. Both use a range of letter grades to rate investment grade bonds and junk bonds (bonds with risk valuations as high as stocks without the expected return of stocks–yes, there is no good reason for ordinary investors to need junk bonds in their portfolios.)
Until well into the 20th century, investment banks and brokers put their reputations behind the investments they offered. The rise of self-appointed rating firms and their evolution into watchdogs of the market coincided with the decline of broker responsibility. Today, brokerage firms live in a caveat emptor world where they and their individual stockbrokers can legally offer and sell you stock without disclosing key facts that should affect your buying decision. They can legally make a dud sound better than it is. (Financial advisors have a much higher fiduciary duty to clients than brokers.)
Naturally, brokers would rather avoid the rating step, but they can’t. There are too many large institutional investors and financial advisors who won’t invest without that rating. Most require that investments meet the “investment grade” standard. Some will only invest in Aaa bonds, such as U.S. Treasuries. Institutional investors without their own large team of analysts (which is to say nearly all institutional investors) rely heavily on the due diligence of Moody’s and Standard & Poor’s to separate quality investments from financial snake oil.
And then came the 2008 crash, after which it was revealed that the ratings agencies had overrated investments across the board and given high “investment grade” ratings to junk investments. Instead of being watchdogs, they were lapdogs of the brokers, helping them to sell toxic investments. Lehman Brothers bonds received a very high rating just months before Lehman went under. Scores of bundled mortgages (aka ticking time bombs) went into portfolios across America, their owners confident that they were holding low-risk investments.
There is something particularly venal about overrating bonds. At least stock buyers know they are taking on risk. Bond buyers are looking for safer investments to preserve capital. Bond investors include the extremely wealthy but also vulnerable older investors who can’t afford big short-term losses.
How such large gaps between rating and reality happened is relevant to the SEC and Department of Justice, and it no doubt involved shortages of true investment grade bonds in the middle of the last decade, but for purposes of this discussion, the takeaway is the very large black eye the ratings agencies acquired for failing to do their job.
Drawing a Line in the Sand
And that brings us back to the recent ratings announcement. The ratings agencies are in a place now where investment professionals are suspicious of investment ratings, yet their funds and their clients expectations are still tied to ratings as if the crash never happened. Institutional funds still have a paper requirement for investment-grade bonds, but the managers of those institutional funds don’t fully trust the ratings they see.
The ratings agencies got in trouble by not standing up to large investment backers and calling out problems they saw. Therefore, the best way to prove that they are serious about earning back their credibility is to make tough calls against big investment backers.
No one is bigger than the United States Treasury, not just in terms of value in the market but in trustworthiness. When the market crashed in 2008, investors all over the world flocked to U.S. Treasury bonds as the highest ground during rising water. Demand was so high that Treasuries briefly paid a negative interest rate—yes, investors paid for the security of parking their money with the U.S. government. Aa bonds don’t inspire that kind of confidence.
So it would take some world-class steel for a rating agency to call out a problem at the U.S. government, right? That had to be at least one thought at the ratings agencies as they sent out their “downgrade watch” notice: earning some badly needed credibility points for calling out the big guys. But that is only how it plays in the United States, where we receive only a fraction of the world’s news. Another consideration is establishing credibility in a world that views both ratings agencies as tied to (and therefore prejudiced toward) the U.S. Of course, state bias doesn’t bother China, whose own Dagong Credit Rating Agency downgraded (not just warned but downgraded) the United States last Monday, just before Moody’s and Standard & Poor’s made their announcements on Wednesday and Thursday, respectively. Ironically, Moody’s and S&P’s bids for credibility gave Dagong credibility.
These announcements put the U.S. and the world on notice that U.S. ratings agencies are watching the U.S. and are willing to call out credit problems. Taken together, all three announcements are moves in a giant chess game of global finance.
The U.S. made it easy to be negative. The ratings agencies didn’t have to make a judgment call on our currency supply, trade imbalance, unemployment, deficit, or any number of complicated economic factors that might impact our creditworthiness—though these things weigh on investors’ minds. They were able to base their calls on the debt ceiling debacle.
The complex financial balance the U.S. government must sustain is much more intricate than any family’s budget. However, raising the debt ceiling is something like a family ordering more checks from the bank. It doesn’t change the amount of money owed, only how easy it is to pay bills. Ratings agencies are on pretty safe ground saying that if the government can’t sort out a simple thing like this, maybe its ability to handle the tricky stuff should be reexamined, too.
This underscores the importance of the debt ceiling debate and exponentially increases the significance of resolving it. The debt ceiling may be an arbitrary, artificial number, but if enough people—especially important people—believe it has meaning, then it does. And that goes for the fact that we actually “hit” the debt ceiling in May. If Moody’s thinks August 2 is the important date, then August 2 becomes the important date. In fact, because it is an arbitrary, artificial number, it is driven by perception far more than the real ability of the U.S. to pay its debts.
Moody’s has threatened to downgrade the U.S. if the deadline passes without a resolution, whether or not any actual default occurs. Standard & Poor’s has threatened a downgrade just for making what should have been a nonevent into a big deal. Do these announcements undermine trust in U.S. Treasuries today? I don’t think so, but they definitely draw a line in the sand between those who want the U.S. to succeed and those who want to see it stumble.
Preparing for the Worst
There are also darker ways to interpret the announcements by Moody’s and S&P, both pro-American and anti-American.
Investment insiders who still think U.S. ratings agencies are tied too closely to the financial industry they are supposed to regulate see this as the U.S. financial industry expressing its own displeasure through the ratings agencies. Writers who have interpreted it this way say that the Republicans are being spanked by their benefactors, told to quit screwing around and raise the debt ceiling before they embarrass themselves further. This version seems perfectly plausible. I would even prefer it to be true because it would put both the ratings agencies and the financial sector in a pro-American position, pressuring the U.S. to do what is in its best interest.
The anti-American way to interpret these threats is frankly depressing but no less plausible. “Business” is not just one set of interests in this country. There are businesses whose profits add to the growth of the economy, and there are businesses that siphon profit away from the economy. The Chamber of Commerce, ALEC, and Congressional Republicans have been working for the siphoners, and there are still plenty of growth businesses and Republican voters that don’t realize this.
The siphoners can afford to bet against the U.S. because they are not reliant on the success of the U.S. They control money all over the world. They can make much more betting against the U.S. than betting for it because the U.S. is so very trustworthy. If the world were a horse race, the U.S. would be the heavy favorite: short odds for winning, long odds for losing.
Felix Salmon is correct in saying that the permanent, belly-up default of the United States Treasury would be an impossible to hedge, end-of-the-world kind of event. But a downgrade is still losing. S&P has left itself the option to downgrade no matter what happens. Moody’s has committed to downgrade if the August 2 deadline passes. Imagine a possible scenario where Republicans choose to hold out on raising the debt ceiling until the evening of Thursday, August 4:
1. Buyers for U.S. Treasuries will thin out
- As the deadline gets closer, investors will start selling off Treasuries because they aren’t sure what will happen.
- Once the deadline passes, Both agencies downgrade the U.S. from triple-A to double-A.
- Institutional investors that invest only in Aaa bonds will be forced to either liquidate their Treasuries or not renew them at maturity, depending on how strict their prospectuses are.
- With more sellers than buyers, the Treasury may have to step in to redeem Treasuries. Depending on the amount of redemption, this could cause a small disruption or a large upheaval to the nation’s cash flow, with or without a new issuance of currency.
2. The U.S. will lose its financial preeminence for the indefinite future.
- U.S. Treasuries will lose their status as the world’s financial high ground.
- Bonds of other countries will gain status and investors relative to the U.S.
- China, especially, is in a position to advance its standing and win the big prize of global financial preeminence.
- Other winners will include companies and investors who have bet on China’s ascendancy, and that includes a lot of U.S.-based multinational corporations that are no longer dependent on the U.S. economy for profit.
3. The perception of failure triggered by passing the deadline will cause unknowledgeable investors to panic
- On August 3 and 4, the market will have two days of general panic trading across all U.S. asset classes
- In anticipation of the crisis resolution, insiders will place their orders at the close of business Thursday or in illegal after-hours trading (not much enforcement these days).
- Friday August 5, the market will start to settle down. Fortunes will be made and lost.
4. Present holders of U.S. debt will suffer no losses (unless they panic)
- Once the debt ceiling is raised on August 4, existing U.S. Treasury bonds will be worth less on the secondary market than they were before the downgrade. However, if investors hold them until maturity, they will receive the same value they would have received before. Thus, investors like China and Goldman Sachs will sustain no net losses.
5. Taxpayers will take the future hit for delaying raising the debt ceiling
- Bonds issuers who can’t claim the highest credit rating must offer more return to draw in investors. Going forward, that means U.S. Treasuries must pay more to investors to get the same amount of working capital.
- That higher return will come from the pockets of taxpayers, whether by direct taxes or higher prices on imports or budget cuts or any number of ways life can get more expensive.
In this way, anti-American interests within the United States can cause significant financial harm to the U.S. and its citizens without damaging their own net worths.
Moody’s and Standard & Poor’s have drawn the line, all right. Watch very carefully who lines up on which side.
Disclosure: I used to work for a financial planner.