It’s the credit rating agencies that need to be downgraded

Civitas, 4 August 2011

By Peter Gambrill

We know now that the US debt deal has cleared its final hurdle by passing the Senate and being signed into law. The deal wrangled over by Republicans and Democrats left the world’s largest economy on the brink of financial suicide. Although the alarmist predictions of immediate market freefall and default were probably overblown, given that tax revenues would have more than covered the interest payments on bonds already issued, there would have been serious effects of failing to reach an agreement. Immediate cuts to federal spending would have been forced on the Obama Whitehouse and a loss of credibility in the US political system would have made investors more wary in the future.

However despite this $1tn commitment to reducing the US deficit, threatening sounds of a possible downgrade of US debt by the rating agency Standard and Poor continue. They give the US a 50:50 chance of being downgraded, as they argue a $4tn deficit deal is needed in order to maintain the AAA rating. In fact a Chinese ratings agency, Dagong Global Credit Rating, has already taken action and downgraded US debt from A-plus to A.

Theoretically, credit ratings agencies have an important role to play in the financial market. They can help overcome information problems by valuing the credit risk of an asset independently of the sellers’ biases. Also they help lower the costs of acquiring this information for market participants, many of whom lack the resources or skill to make their own evaluation.

However this raises some questions. Are credit rating agencies’ pronouncements reliable and should we listen to them?

Questions of reliability arose after the complete failure of ratings agencies in predicting the global financial crisis, something they helped create by overrating assets back by subprime mortgages. As a result, some investment firms have set up in-house ratings teams, demonstrating at least not all investors take the words of Moddy’s or Fitch or S&P as gospel.

However, the most powerful and current criticism of such agencies comes in the form of their double standards in dealing with public-sector debt compared to private. For many, there seems to be an ideological bias against public-sector debt with agencies using their power over markets, or at least perceived power, to force austerity on economies fearing crippling interest rates if they were to be downgraded. This fear of the “invisible bond vigilante” as economist Paul Krugman calls it, has shaped many governments actions in recent times and in this narrative it’s the credit rating agencies that are the generals of the vigilante army.

The threatening tone of S&P’s decision to put the US on credit watch and demand $4tn’s of budget cuts seems to be completely removed from their own research. In June 2001 S&P published a report that said:

“The number of defaults and cumulative default rates are extremely low for public finance obligations rated by Standard & Poor’s” and that “no defaults of ‘AAA’ or ‘AA’ rated debt occurred in the 1986-2003 period.”

Six further studies on public bond default between 2004 and 2008 all came to the same conclusion. Moody’s has conducted similar studies, one in November 2002 found that:

“The 1, 5, and 10-year cumulative default rates for all Moody’s-rated municipal bond issuers have been 0.0043%, 0.0233%, and 0.0420%, respectively compared to 0.0000%, 0.1237%, and 0.6750% for Aaa-rated corporate bonds during the same time period.”

This in other words concludes that public bonds of all ratings, including the lowest, have on average a lower default rate than the highest rated corporate bond.

What effect does this bias have on the interest rates of government debt? Remarkably little, if we look at the last downgrade of a major economy, Japan.

Can you see when it happened? It was in 2002 when S&P cut Japans credit rating from AA to AA-minus. What we might take from this is that these rating agencies don’t speak for the market.

This insight has certain implications for government policy. Firstly governments don’t need to base their fiscal plans around threats of ratings downgrades and secondly there is a case to be made for the establishment of a truly independent body to assess the security of public debt, initially on a national scale but with the ultimate goal of an international body which is well respected and not profit driven. Ratings agencies should no longer be given the trust of governments and should not be relied upon for informing public policy.