18 August 2011

U.S. Credit Rating: ‘AAA’ or ‘AA+’

On 2 August 2011 Moody’s confirmed US Aaa rating, assigned negative outlook. On 5 August 2011 S&P announced* that “United States of America Long-Term Rating Lowered To 'AA+' On Political Risks And Rising Debt Burden; Outlook Negative”. Although not unexpected, the reaction to S&P’s announcement was rather dramatic: by the next morning the news channels were flooded with news about the “unprecedented blow to the world's largest economy”; the first debt downgrade since 1917, eventually raising borrowing costs for the American government, companies and consumers; Treasury bonds, once indisputably seen as the safest security in the world, now rated lower than bonds issued by countries such as Britain, Germany, France or Canada; U.S. Treasury questioning the calculation; France questioning US downgrade while being worried about its own top-tier rating; etc. On 16 August 2011, the third main rating agency, Fitch, affirmed the United States at ‘AAA’ and assigned stable outlook* which helped to calm down emotions around S&P’s downgrade.

Who is right: S&P, Fitch or Moody’s? Is US still an ‘AAA’ country or now an ‘AA+’ country? Does it matter?

Note that while having slightly different rating criteria, all three major rating agencies are basically looking at the same things when rating a sovereign:
* Institutional strength, political processes and effectiveness of policy making
* Wealth, size, diversity and dynamism of the economy, and factors affecting it
* Country’s external finances, i.e. assets and liabilities along with trade and financial flows between residents and non-residents
* Public finances, incl. budget deficit, gross and net government debt, interest expenses
* Money and monetary policy, incl. status of the country’s currency, flexibility in making monetary policy etc.
Several factors are being considered in combination rather than separately. Rating process itself involves lots of qualitative discussions and future forecasts. From rating methodologies we can find several “justifications” about why high debt burdens are acceptable for the countries generally referred to as “advanced”, for example. Thus there clearly is subjectivity involved; this is natural of course, yet should be taking into account when interpreting and using process outcomes.

Let’s take a quick look at how the rating agencies rationalised their recent rating decisions on the US long-term sovereign credit rating.

On August 2, Moody’s communicated that:
* The Budget Control Act of 2011 passed on the same day by US Congress and signed into law by President Barack Obama is a first step toward achieving the long-term fiscal consolidation to maintain the US government debt metrics within Aaa parameters over the long run. (Note: “a first step”) However, wide political differences that characterised the accompanying debt and fiscal debate can prevent effective policymaking in the future.
* There would be a risk of downgrade if (1) there is a weakening in fiscal discipline in the coming year; (2) further fiscal consolidation measures are not adopted in 2013; (3) the economic outlook deteriorates significantly; or (4) there is an appreciable rise in the US government's funding costs over and above what is currently expected. (Note that with its own rating decision, Moody’s can affect the funding cost. Note also that the recent downward revisions of economic growth rates and the very low growth rate recorded in the first half of 2011 call into question the economic recovery.)
* It expects to see a stabilization of the federal government's debt-to-GDP ratio not too far above its projected 2012 level of 73% by the middle of the decade, followed by a decline. (Note that based on the Fitch’s forecast accompanying the Fitch’s rating decision for example, the federal government’s debt-to-GDP ratio is expected to deteriorate from 74% in 2012 to 83% in 2016.).
* The US Treasury's cost of borrowing has remained low despite the recent political uncertainties surrounding the debt limit and the long term fiscal outlook. (Note the acknowledgment of uncertainties and ignoring the fact that Fed buying Treasuries lowered Treasury’s cost of borrowing artificially).

On August 8, while quite obviously feeling the pressure from S&P’s downgrade and the need to defend its own position, Moody’s came out with the “Key Drivers Behind Moody’s Confirmation of the US Aaa Rating”:
* The unparalleled diversity and size of the US economy and its long record of relatively solid economic growth, based on both demographics and productivity
* The global role of the dollar, which underpins continued demand for US dollar assets, including US Treasury obligations
* Institutional strength very high even if political parties disagree; while the particular measures implemented during the recent financial crisis can be debated, the government and the central bank responded quickly and vigorously to the crisis.
At the same time it also (once again) pointed out that relative to other large Aaa-rated governments, the US debt position is "somewhat high" (cause for negative rating outlook). It also noted that the debt limit process adds a low “event risk” (read: the risk that if the debt ceiling is not increased, US government would default).

In its 5 August announcement, S&P stated that:
* The downgrade reflects their opinion that the fiscal consolidation plan that the Congress and the Administration had recently agreed falls short of what, in their view, would be necessary to stabilize the government’s debt dynamics. (Note that on principle, both Moody’s and Fitch agree with this statement.)
* More broadly, the downgrade reflects their view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened since spring (which is where the others appear to disagree).
* They are pessimistic about the capacity of Congress and the Administration to be able to come up with a broader fiscal consolidation plan that stabilises the government’s debt dynamics any time soon (again, Fitch and Moody’s seem to be more optimistic here).
* Rating outlook is negative and rating could be lowered to ‘AA’ within the next two years given the higher general debt trajectory than assumed (which in Fitch’s case would most probably lead to no more than negative outlook to the triple A rating; a one notch downgrade would be much less likely).
* The other factors than the rising public debt burden and the perception of greater policymaking uncertainty are viewed as broadly unchanged.

In its rating affirmation on 16 August, Fitch stressed the following:
* The affirmation of the US 'AAA' sovereign rating reflects the fact that the key pillars of US's exceptional creditworthiness remains intact: its pivotal role in the global financial system and the flexible, diversified and wealthy economy that provides its revenue base.
* Monetary and exchange rate flexibility further enhances the capacity of the economy to absorb and adjust to 'shocks'.

The rating agency, however, could not ignore that:
* The fiscal profile of the US government has deteriorated sharply and is set to become an outlier relative to 'AAA' peers. (Note that comparison with peers is a moving target, which implies that if the public debt situation of these peers gets worse, it would be acceptable for US to have higher public debt as well.) Fitch however projects (or more precisely, hopes) that the public debt will stabilise in the latter half of the decade at the limit of the level of government indebtedness that would be consistent with the US retaining its ‘AAA’ status.
* The Budget Control Act (BCA 2011) passed into law on August 2 would only bring US public finances closer to a sustainable path (only closer, not to the sustainable path). The judgement (read: hope), however, is that the emerging public and political recognition of the necessity of fiscal consolidation will be translated into specific and timely measures.

As we can see, there is no major disagreement between the three rating agencies. More-less all the debate revolves around the political will and U.S. public debt compared to the other ‘AAA’ countries. The difference in the assigned ratings comes from Fitch hoping, S&P remaining pragmatic and Moody’s being slightly optimistic in the frame of their defined rating criteria / sovereign rating methodology.

Based on the above and taking into account that it is even not possible to reliably distinguish between the probabilities of default of an ‘AAA’ country and an ‘AA+’ country, it is not nice (or more precisely it is almost criminal) to scare US home owners that their borrowing costs will increase (significantly) because of the current US downgrade by S&P. This is the more so given that generally all ‘AAA’ and ‘AA’ rated securities are assigned into the highest credit quality step when it comes to regulatory capital requirements and liquidity requirements for banks. Thus: start worrying about the US rating if it falls below ‘AA-‘.  If the borrowing costs rise indeed (as they are bound to do at some point), the reason is to be found from somewhere else.

What one should be much more considerate are:
1) too large role that the three major rating agencies play in global finance and hence, in economy
2) limitations in the definitions and rating methodologies, and/or aspects that rating agencies just ignore in rating process
3) reflexivity of the rating process
4) political and other pressures put on rating agencies.
These four issues are fundamentally far more important than the debate about whether US should have an ‘AAA’ rating or ‘AA+’ rating.

The domination of S&P, Moody’s and Fitch on credit rating market probably does not need a comment. It is the norm for debt issuers to first obtain ratings from Moody’s and S&P, and then turn to Fitch. But that’s only one thing. What matters even more is that the ratings assigned by these three agencies are the same written into the regulatory frameworks and laws (e.g. belonging by default to the list of ECAIs in Basel II framework). This is what makes them powerful and respectable indeed, even if e.g. David Wyss, a former chief economist at S&P has been cited by Forbes saying: "The credit agencies don't know any more about government budgets than the guy in the street who is reading the newspaper."

When it comes to rating methodologies and aspects ignored by all major rating agencies, then perhaps the most controversial parts relate to the monetary policy and its effectiveness, as well as regulatory framework for the financial system. For example, US scores high because USD serves as a reserve currency and US has the ability to “print itself out” from the literal default. In general, rating agencies also appear to be satisfied with the US institutions. They do not comment the very fact that these same “effective institutions” failed with the proper regulation of financial sector, were unable to prevent the crisis, or even worse, contributed to it. They ignore in their rating decisions that QE1 and QE2 proved to be inefficient in reviving the real economy. If we estimate a country’s probability of default in nominal terms, it may be ok. But is it ok to rate a sovereign’s probability of default this way? Consider the question for example from China’s perspective.

By reflexivity of the rating process I first of all keep in mind the fact that the very same ratings assigned by the rating agencies affect the inputs of the rating process. For example, if a country’s sovereign rating is downgraded, its cost of borrowing and thus interest expenses increase. This means higher debt which in turn should lead to the lower rating. Thus, with their own rating assessments such dominating rating agencies like Moody’s, S&P and Fitch can lead a country closer to default. That’s one reason why it would be extremely complicated to assign US (or any other currently top-rated country) a lower rating than ‘AA-‘.

Pressures on rating agencies again need little comment if any – consider for example how the US downgrade by S&P was “welcomed” by the authorities.

So how could we assign US a more reliable rating? It seems that we need many independent rating analysts, whose assessments are automatically aggregated to the final result. In other words: end the monopoly of The Big Three. Any better ideas?

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1 comment:

  1. I would first like to applaud the article for it's excellent writing and content!!! There needs to be more stuff like this written. If there was more social awareness of this subject before this downgrade, then perhaps we could have avoided the collective complacency that allowed it to occur in the first place.