Rating the USA - credit where credit's due?

Robert Keavney agrees that the USA should be stripped of its AAA rating – and wonders whether it could be downgraded further.

Will the next change to the credit rating of US debt be down or up? According to Standard & Poor’s (S&P), AAA means ‘extremely strong ability to meet financial commitments; highest rating’.

Howards Marks, chairman of Oaktree Capital (Memos From Our Chairman September 7, 2011) notes that “the US can print money, so they presumably do have an extremely strong ability to meet their commitments.

But do they deserve the highest rating? If the USA was AAA in 2000 when running a surplus, its national debt was far smaller and Washington functioned more constructively, mightn’t it deserve a lower rating today?”

Undoubtedly, Switzerland, China, Australia and New Zealand each have materially stronger ability to meet their commitments than the USA, if we look at capacity to pay measured by debt as a percentage of the gross domestic product (GDP). 

But what about America’s capacity to print money? Virtually every nation can print unlimited amounts of money, except the poor Europeans shackled to the euro.

If capacity to create money is sufficient to qualify for an AAA rating, then almost every country would deserve it – including Zimbabwe, which has thoroughly proven its skills in money creation.

Recognising this, we must conclude that credit ratings need to take into account more than the ability to print oneself out of disaster (or into it, in Zimbabwe’s case.) On these grounds it does seem reasonable to remove the highest rating from the US.

Ratings agencies

S&P unfairly got the credit – or blame – for downgrading the US to AA, yet it was only the second ratings organisation to do so. Egan Jones Ratings (EJR) led S&P in downgrading Uncle Sam. 

The business model of the main research houses has been much criticised as ratings are paid for by those rated. This is claimed to have contributed to many inappropriate outcomes, from the ridiculous granting of AAA to low grade collateralised debt obligations (CDOs) which contributed to the subprime bubble, to maintaining Enron’s triple AAA rating until four days before it filed for bankruptcy. 

EJR is paid by its clients (ie subscribers for their service), not by the entities they rate. This business model avoids conflicts of interest. In my view, all ratings and research organisations should operate this way, just as financial advisers should.

Research by academics and the Federal Reserve have found that 95 per cent of upgrades/downgrades by EJR tend to be followed by S&P, Moody’s and/or Fitch.

Examples of EJR recognising problems before other ratings agencies acted include its work on New Century, homebuilders and the monolines in the recent bubble, and Enron and WorldCom in the previous cycle.

Given the widespread concern about the business models of rating agencies in the wake of the sub-prime debacle, it is encouraging that a new breed of rater is emerging, and seemingly doing a better job.

In the case in point, the downgrade of US debt, EJR was first to do so. This was largely missed by the world’s media.

US junk bonds?

However, Grant’s Interest Rate Observer, a US-based subscription newsletter in its 29th year, can perhaps claim to have been first to identify the risk of US debt being rerated. (Incidentally, Grant’s was also the first publication, to my knowledge, to detail the faults with CDOs and predict their catastrophic future, before the financial crisis.)

From 1985 to 2010, Grant’s has “presented the financial condition of the US government in the form of a (series of) junk bond prospectus.” In other words, Grant’s sets out the financial position of the USA as it might look to prospective purchasers of government bonds, under a requirement for full and frank disclosure.

Grant’s notes that “invariably we have found negative cash flow, high and rising contingent liabilities and a worrying crutch in the reserve-currency privilege”(Grant’s August 12, 2011).

In the foreword to its most recent ‘prospectus’ dated March 5, 2010, Grant’s observed:

“For its exemption from the reporting requirements of the 1933 Securities Act, the US Treasury may thank its lucky stars.” 

Under the various risk factors itemised as applying to the USA is the following prescient assessment:

“Ratings agencies may withdraw or downgrade the US governments current AAA rating without notice,” and adds “the increase in government debt as a result of the financial crisis may lead to greater concern over sovereign risk”. This was published more than a year before the ratings downgrade.

Other risks for US Treasury investment described in the prospectus included (note all figures are for financial year 2009, the last data available at the time of Grant’s publication): 

• The US economy is heavily indebted at all levels. Total debt represents 369 per cent of GDP.
• The government faces growing mandatory commitments for retirement insurance and health care. Treasury estimates that the net present value of these future obligations was $46 trillion; 
• The government is exposed to large contingent liabilities from its intervention on behalf of numerous financial institutions during the global financial crisis. These include Fannie, Freddy, Federal Deposit Insurance Corporation and the Federal Housing Authority.
  “Interventions since the start of the crisis have totalled US$8 trillion or 55 per cent of GDP… It is unlikely that private risk can be continuously transferred onto public balance sheets without eventually impairing the credit worthiness of the government”;
• US states and municipalities are experiencing severe economic distress and may require federal intervention;
• The Federal Reserve Bank is exposed to significant credit risk as a result of assets taken onto its balance sheet since 2007. Both the government and US banks could be impacted negatively by problems in the Fed’s portfolio;
• Approximately 50 per cent of US government debt is held by foreign official institutions. Therefore demand for the greenback is largely in the hands of foreigners. Thus the exchange rate could depend materially on their action;
• The US has substantial overseas commitments including involvement in two wars, plus 716 overseas sites in 38 foreign countries.
  It is also committed by alliances as the de facto defender for many nations and could be drawn into conflicts. It is also de facto guarantor of shipping lanes in the Panama Canal, Red Sea, Persian Gulf and Strait of Malacca. Historically, the financing of military conflicts has imposed stress on sovereign finances;
• The Government Accountability Office audits the finances of the USA and has declined to offer an opinion on their accuracy, due to identifying 38 material weaknesses in 24 government agencies. (Incidentally, this is the 14th year in a row that it has declined to offer an opinion);
• Improper or erroneous payments were made by certain federal departments totalling approximately $100 billion, or 5 per cent of the outlays of the relevant departments. This amount is double the amount two years earlier; and
• Elected officials may not take steps to ensure long-term debt sustainably and may take actions counter to the interests of bondholders.

Imagine the reaction of investors to a prospectus, offered by a corporation, which revealed heavy indebtedness, overlaid with massive future obligations plus large potential contingent liabilities in several areas, whose accounts are of dubious accuracy and whose directors may act counter to investors’ interests. And which yields only 2 per cent.

Junk bonds (though lacking a junk bond yield) is how Grant’s describes it, with tongue only half in cheek.

Only ownership of the dollar printing press provides reassurance that America will be able to finance the growing debt pile. Yet, as Grants notes, printing money may (not will) deflate the value of the dollars, and may cause exchange rate losses.

There is another risk flowing from all this. If the US is fundamentally weakened, and the greenback becomes less sound, it could even become possible that US dollars might lose their role as the world’s reserve.

This seems unthinkable, just as it may have been unimaginable early in the 20th Century that the pound sterling would cease to be the reserve currency. Reserve currencies have come and gone over the centuries. World demand for dollars would plunge, should it ever cease to be the reserve currency.

This is a non-trivial list of risks.

Round the twist

Meanwhile, the Fed continues its dangerous hyper-activity. The underlying problem in America is over-indebtedness. The Fed can’t fix this. Thus all actions by the Fed will fail to produce the desired result. Yet it can, and in the case of quantitative easing already has, produce negative consequences. This, however, won’t stop them.

The first phase of the Fed’s Operation Twist resulted (at date of writing) in a yield on five year Treasuries of 0.85 per cent while the rate for three months is -0.01 per cent. 

As if American banks weren’t weakened already. Lending institutions make their profits largely by borrowing short and lending long at a higher rate.

However, with a margin of only 0.86 per cent, before costs, from borrowing for three months and lending for five years, this activity will be far less profitable.

I’ll close on the subject I began with. Guess which country has the highest government debt as a percentage of GDP, among the USA, Portugal and Spain: not Portugal or Spain. I do not mean to suggest that the US is actually worse off than the Iberian nations – but it is a striking statistic.

So will the next change in US credit rating be up or down? We shall see.

Robert Keavney is an industry commentator.