I am still on alert for a larger pullback in the market. The larger picture suggests the SPX will li...
After the U.S. downgrade: A reminder of how much debt still needs to be re-rated
08/23/2011 8:30 am EST
What’s happened to the debt of the United States since then?
Treasuries have rallied and sent yields to historic lows. Last week the yield on a two-year Treasury fell to 0.19%. The yield on a 10-year Treasury closed the week at 2.06. That was slightly above the low set on Thursday of 1.97%. That was the lowest yield on the 10-year Treasury since 1950.
There’s no way to escape a certain amount of Schadenfreude. There is pleasure, admit it, in seeing the market thumb its nose at Standard & Poor’s, the credit rating company that got the mortgage-asset market so terribly wrong and helped create the global financial crisis by giving AAA ratings to so much paper that quickly demonstrated that it didn’t deserve an AAA rating by collapsing in price as the underlying mortgages went sour.
But I wouldn’t let the grim pleasure at Standard & Poor’s discomfiture become your primary emotional reaction to the rally in U.S. debt markets. That main emotion should be worry. This rally isn’t a sign of health in the financial markets.
First of all, the rally is a sign of just how much fear stalks global financial markets—it’s not so much that investors love U.S. Treasuries but that they hate almost everything else more. The money pouring into Treasuries is money that’s not going into loans or capital investments that expand the global economy. Money is cheap if you look just at Treasury yields but it’s not readily available to all the credit-worthy borrowers who need it. Just ask a prospective homebuyer in the U.S. who has just been turned down for a mortgage. Or small businesses in Japan or China that can’t get financing at anything less than ruinous rates—if they can get financing at all.
Second, the rally is a sign of just how unmoored the global financial system has become from past standards—and how much work still needs to be done to create a new system. It’s one thing to laugh at Standard & Poor’s ratings; it’s something else entirely to come up with a new system that accurately reflects credit risk and credit worthiness. And without that some system to create confidence among buyers and sells whole swaths of modern finance—the derivatives market comes to mind—become, at the least, less efficient and, at worst, frozen with indecision.
Standard & Poor’s decision to downgrade the credit rating of the United States—and the way that the company handled that decision--has shown how badly the current system is broken.
First, when Standard & Poor’s announced the downgrade, it got caught in a $2 trillion math error. Standard & Poor’s initially over-estimated the size of future U.S. deficits by $2 trillion, an error that U.S. Treasury officials rushed to publicize. Standard & Poor’s admitted the error and lowered its projection for the ratio of government debt to GDP for 2015 by two percentage points. In its initial downgrade the company said that the ratio of U.S. debt to GDP would be 77% in 2015 and hit 78% in 2021. A shift from 77% to 75% indeed doesn’t seem significant if you buy into Standard & Poor’s framework for making it decision.
But instead of leaving the defense of its decision there, the company then managed to call into question that entire rationale for its downgrade. The $2 trillion math error wasn’t significant, Standard & Poor’s went on to argue, because it had based its decision on its judgment of U.S. politics. Congress had finally passed a package that combined an increase in the debt ceiling with $2.4 trillion in spending cuts over 10 years But Standard & Poor’s had calculated that it would take a $4 trillion package of cuts to demonstrate the U.S. government’s commitment to long-term deficit reduction. Realizing, I guess, that you can’t argue that a $2 trillion math error is insignificant but a $2 trillion shortfall in the deficit reduction package is significant, Standard & Poor’s said its downgrade was based not on the result of the battle in Congress but on what the company called the “extremely difficult” political discussions. The “debate this year has highlighted a degree of uncertainty over the political policymaking process which we think is incompatible with the AAA rating, Standard & Poor’s analyst David Beers told a conference call after the August 5 downgrade.
Which, to me, makes it look like Standard & Poor’s is just making it up as it goes along. The trends in the U.S. deficit numbers have been clear for a decade or more. The demographic facts of life that have been driving the explosion in medical and retirement costs aren’t new. And while U.S. politics are nastier than ever, they don’t represent some sudden turn from fiscal responsibility to fiscal recklessness.
Congress is suddenly unwilling to deal honestly with the U.S. deficit? Come on, Standard & Poor’s.
A number of critics of the downgrade decision have questioned Standard & Poor’s sudden assertion of political expertise. They’ve certainly got a point. What expertise does this company have in political analysis?
But to me it’s the shift in criteria that’s more disturbing than the issue of Standard & Poor’s credentials in political analysis. If today we’re suddenly going to rate debt based on politics, won’t we be looking at downgrades across the debt landscape? And if today credit ratings expand to political analysis, what might they expand to include tomorrow?
Just look at some of the anomalies that a political credit rating element might have to address. For example, after the Standard & Poor’s downgrade, the United States has the same credit rating as Belgium. Now U.S. politics may be difficult but Belgium hasn’t had a government of any sort—the country’s parties are deadlocked and no one has been able to form a coalition government--for more than a year. If we’re going to start including political judgments in credit ratings, shouldn’t Belgium get a downgrade?
And how about Japan? The country carries the developed world’s highest debt GDP ratio; it has the fastest aging population in an aging world; it’s economy seems mired in an endless recession; and it has a completely dysfunctional government where any reform is blocked by an electoral system that leaves the real power in the hands of an aging rural cabal. Shouldn’t Japan get a downgrade?
Once you start down this road, you quickly come to the conclusion that the credit ratings of governments at all levels need revision—and not on new, only recently discovered grounds.
For example, Fitch Ratings recently lowered its rating on New Jersey’s general-obligation bonds to AA- (the fourth highest grade), citing “mounting budgetary pressure” from pension and employee benefit deficits, high state debt levels, and persistent budget gaps. Moody’s Investors Service had cut its rating to Aa3 in April and Standard & Poor’s to AA- in February.
I’ve got a couple of problems with those downgrades. First, New Jersey failed to make the full level of payments required to fund its pension plans for much of the last decade. The ratings companies only discovered that this year?
Second, if the United States is AA+, can New Jersey be AA-? The United States can, of course, print money—New Jersey can’t. Social Security needs a tweak certainly but its problems pale in comparison to that of New Jersey’s pension system. And New Jersey’s fiscal problems may begin with pension funding but certainly don’t end there. The state’s voters demand property tax relief and the state faces a big bill for education according to the State Supreme Court’s reading of the state constitution.
I don't mean to pick on New Jersey—the state is merely one example of a problem that reaches from the over-extended municipal governments of China to the national governments of the United States and France to asset-backed debt left over from the great mortgage meltdown. (The story in London, where I am right now, is about the biggest banks in the United Kingdom transferring billions in illiquid assets left over from financial crisis days from their own balance sheets to those of their employee pension funds. You might ask if the banks’ underfunded pension funds will suddenly get healthy with an infusion of assets that the banks haven’t been able to sell in the financial markets.)
The world is still full of assets left over from the financial crisis that can’t be accurately rated—or priced. And now the Standard & Poor’s downgrade of the United States reminds us that there’s a larger problem: that there’s another set of assets that need to be re-rated and re-priced too.
How much of this risky stuff that needs re-rating is out there? How are investors going to re-rate it? And how much trust should anyone put in any new ratings when the old ones turned out to be so problematic?
The difficulty in answering those questions explains part of the rush to U.S. Treasuries. And it certainly supports the arguments of those who say the financial markets have a lot of healing to do before investors will see anything resembling the old normal.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. For a full list of the stocks in the fund as of the end of June see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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