Sunday, August 7, 2011

Reflecting on Rating Downgrade

On Friday night, for the first time in 70 years, Standard and Poor’s (S&P) downgraded the sovereign credit rating of the United States from AAA to AA+. News of the potential downgrade was leaked Friday morning spurring much discussion on Twitter. Friday afternoon it became clear the Treasury, Administration and Congress had been notified of the impending downgrade and seemingly allowed a rebuttal. Since the official announcement, nearly all financial discussion has focused on the uncertain consequences and baffling decision by S&P. Later today I hope to provide some commentary on the possible repercussions of the downgrade, but for now I actually want to take a moment to defend S&P when seemingly nobody else will.
Before placing judgment on the ensuing discussion, please recognize that I do not believe S&P or the other Nationally Recognized Statistical Rating Organizations (NRSRO) are deserving of the legitimacy and power assigned to their credit ratings. Relying on payments from issuers of bonds creates a severe conflict of interest that most notably hurt investors during the widespread misrepresentation of credit risk on mortgage backed securities and other structured finance products. However, many of the current criticisms appear to reflect either a misunderstanding of credit ratings or failure to read S&P’s Sovereign Government Rating Methodology And Assumptions.

Standard & Poor's credit ratings express a relative ranking of creditworthiness” that is primarily free information available to individuals. It’s important to remember that any credit rating is merely the opinion of an independent company. A credit rating may aid an investor in valuing a bond, but should never replace actual due diligence in determining his/her own opinion on an issuer’s creditworthiness. Since credit ratings represent an opinion, I have no qualms against anyone stating their disagreement with S&P’s view. My urge to write this piece is against those commentators claiming, in various forms, that S&P holds no right to have an opinion. These complaints seem childish and perpetuate many of the political weaknesses noted in the downgrade. Ultimately the decision at S&P was made by a group of individuals with similar rights to an opinion on the creditworthiness of the U.S. as anyone else. Going forward I hope discussions will focus on disagreements in rating methodology or the use of credit ratings and not on who deserves an opinion.

Apart from frustration at S&P stating their opinion, a greater proportion of recent discussion seems focused on displaying disgust towards S&P’s rating methodology. While I certainly don’t believe S&P’s sovereign rating system is flawless (if that were even possible), potential errors do not appear as glaring as many have opined. Although the $2 trillion mathematical error sounds bad, the reality is that amount makes little difference in the long-term outlook or reasons cited by S&P for the downgrade.

One frequent objection that stands out is the claim that S&P should not make qualitative judgments regarding the creditworthiness of the U.S. A number of highly educated people have even appeared surprised by this notion. From S&P’s website (emphasis mine): 

Standard & Poor's appraisal of each sovereign's overall creditworthiness focuses on political and economic risks and is both quantitative and qualitative. The quantitative aspects of the analysis incorporate a number of measures of economic performance, although judging the integrity of the data is a more qualitative matter. The analysis is also qualitative due to the importance of political and policy developments and because Standard & Poor's ratings indicate future debt-service capacity.

Clearly S&P has not hidden the fact it makes qualitative judgments and I can only assume this basic statement has been available to the public for years, if not decades. Sudden outrage certainly seems misplaced.

Beyond the fact that S&P uses qualitative measures, the question remains whether or not this practice is valid. To address this issue it’s imperative that the meaning of a sovereign credit rating is clear. From S&P’s Sovereign Government Rating Methodology And Assumptions (emphasis mine):

“All references to sovereign ratings in this article pertain to a sovereign's ability and willingness to service financial obligations to nonofficial, in other words commercial, creditors.”

Ability and willingness are highlighted since they represent the similar dichotomy between quantitative and qualitative. As I’ve stated in previous posts, the U.S. is a currency issuer with debt denominated in its own currency and therefore never faces an inability to pay. Laws, such as the debt limit, reflect self-imposed constraints on the country’s willingness to pay. Fathoming ways to quantify future Congress’ willingness to pay is quite difficult. The reality is that U.S. debt currently only faces default risk related to willingness to pay and that risk is by nature qualitative. Therefore, ignoring qualitative measures would be equivalent to disregarding the possibility that Congress could ever choose to default (and has happened before).

The first downgrade in history has now occurred, which makes it time to address and deal with the consequences. From my perspective, too much time has already been spent degrading S&P and complaining about the decision. If investor’s opinions differ from S&P, than any related sell off in treasuries should provide a nice buying opportunity. If people believe credit ratings are used by investors inappropriately, then they should work to increase education and improve dialogue on the matter. If Congress believes S&P’s critiques were out of line, then they should prove an unbound willingness to pay by removing self-imposed restraints such as the debt limit.

Ten days ago President Obama said the following in a speech on the debt ceiling:

Now we have a AA+ credit rating, to match our (at best) AA+ political system. S&P’s credit rating downgrade only confirmed this belief that most already held. Less time should be spent demonizing S&P and more time focused on rebuilding a AAA political system. When that day comes, I have a feeling the credit rating will also display AAA.

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