Saturday, August 6, 2011

On the S&P debt downgrade

I honestly can't decide whether to say this is unexpected or expected.

Why it's expected: S&P has made it very clear the downgrade occurred because of political gridlock, not because of the size of the debt or the state of the US economy. And they're correct! Nobody in their right mind could look at the last month of US politics and declare US debt almost perfectly safe. Countries rated AAA shouldn't come within two days of openly defaulting on their obligations, and the debt deal doesn't change that. What if Congress hadn't reached a deal in time? What if some quirk of parliamentary procedure delayed the deal past the deadline? When you're walking that close to the wire, there are simply too many things that can go wrong to say the debt is "risk-free." And Congress has made it quite clear that July's standoff will be the norm from here on out. Really, AA+ might be too good for us, even.

Why it's unexpected: on the other hand, it doesn't make any sense to downgrade the debt right now -- nothing's changed in the last few days. And while political gridlock is a perfectly legitimate reason for a downgrade, gridlock has been a reality for a while now. The timing of the downgrade makes me think S&P was waiting to see the final debt deal before passing judgment, which is silly of them. All the relevant facts were in place two months ago: the debt was large, no plausible congressional bargain could reduce it, Congress was a feeble, broken institution, and the economy was lousy.

By having a debt ceiling standoff, Congress was playing Russian Roulette with the economy. You don't need to wait for the result to know that Congress was engaging in some pretty risky behavior.

Which brings me to my final point: the real reason the downgrade happened is because S&P painted itself into a corner. It started issuing edicts: either we strike a deal with $4 trillion in deficit reduction or the US loses its AAA rating. We didn't, so it did.

It was always a bit strange to see an agency charged with passively rating debt trying to influence policy. And this is why: now, it's hard to know to what degree S&P's new rating is because of honest evaluation of the facts, and to what degree it's because of a political position it had staked out in advance and now must defend. S&P might have damaged the America's reputation with this downgrade, but it's damaged its own, too.


  1. The purpose of a rating agency seems to be to inform investors as to the chance of an asset defaulting. This seems important with more complex financial instruments where your average investor wouldnt have any idea how safe a certain asset is. There isnt a single holder of US debt in the entire world that didnt realize how close the US came to defaulting. S & P doesnt have one iota of information more then your average bondholder has on the chances of the US defaulting in the future. So im not really sure why rating of the US debt is even necessary. I (and every bond holder) know the US isnt going to be overtaken by a coup tomorrow that will stiff bondholders, I also know that maybe the next time the debt ceiling limit comes around President Bachmann wont raise it. S & P's downgrade doesnt affect any of our perceptions of the risk associated with holding US debt.

  2. Yeah but as I'm sure you're aware some municipal debt will probably get downgraded as consequence of this, and that drives up borrowing costs for those municipalities, further squeezing their finances, leading to further cuts in services... and so on, and so forth.

    In other words, I think the concern is that when you take something as ubiquitous and fundamental as American bonds, and you start fiddling with their properties, you risk creating all sort of unexpected ripple effects downstream.

  3. If S & P downgrades municipal debt because of this isnt that just saying "the US is less likely to bail out Harrisburg, PA". Im not really sure how the US's debt being downgraded effects how people perceive the likelihood of the US bailing out municipalities. Once again, nothing has changed that the public/market hasnt taken note of. If borrowing rates go up for municipalities it seems like it should be in relation to some sort of belief that the US wont be able bail them out if need be.

  4. To make my points more clear, I basically have two propositions:

    1) The downgrading of the debt by S & P is meaningless because bond holders have their own independent evaluation of the likelihood of US default.

    2) Any municipal debt that is rated AAA has that rating because it is basically insured by the AAA US Debt, if bondholders still have confidence in the US Debt despite its downgrade, they wont lose confidence in the municipal debt because of its downgrade.

    I could be wrong about 1 (and we'll probably find out on monday) but I think 2 follows pretty clearly from 1.