Sunday, August 7, 2011

S&P out on a limb

Last week, I confidently predicted that S&P would not downgrade the US. I reasoned that to take what many will see as an extreme position would erode S&P’s credibility, especially when the other two agencies disagree. (Which, by the way, is an inadmissable reason to maintain a rating, but everyone has a subconscious).

The United States is a very complex sovereign credit, because it prints the global reserve currency, which creates artificial central bank demand for its bonds. Also, as Gavyn Davies points out in today’s FT:

The US cannot be forced to default on debt which is denominated in its own currency while it has huge untapped taxable capacity and a sovereign central bank to boot. It would only default because of the existence of a debt ceiling voluntarily imposed by Congress.

Aside from the optics, was S&P’s decision correct? That depends in part whether one believes that S&P rates sovereigns on the corporate scale. They say they do, but do they really? If one takes their stated methodologies at face value, the downgrade was warranted. They had laid out clear criteria in advance and the criteria were not met (a bipartisan deal to reduce the deficit by an amount sufficient to stabilize the country’s key debt ratios at a level consistent with AAA).

Did S&P do the responsible thing? Yes. Rating agencies are not allowed to have a published opinion that differs from the rating committee’s own internal opinion. When a rating agency downgrades a credit, the issuer suffers (see Enron, AIG, Greece). Rating agencies do not and may not consider the possible  impact on the issuer or on the capital markets. Otherwise no one would ever be downgraded. All issuers are not created equal.

What is the political backwash for the agencies? The usual nonsensical ideas: (1) regulate them more; (2) create more of them (with government money); and (3) reduce their “power”. This kind of talk has been going on since the agencies started downgrading NYC in the 1960s. It erupted after Enron/WorldCom, and again after the CDO mess. Always stymied by that obscure 1789 Constitutional amendment which says something about the press.

I do not see how a government can regulate an opinion provider (aside from fraudulent activities that would apply to all opinion providers). Right now the Italians are “investigating” the rating agencies for publishing opinions with which Sr. Berlusconi disagrees, or finds inconvenient.

I expect the political upshot to be basically nothing, other than the fact that this has embroiled the agencies in domestic politics in the middle of a national political campaign, which is not good.

The one upside is that this event bolsters the agencies’ argument that they are publishers and deserve First Amendment protection (which has been upheld in federal court on multiple occasions).

It is my hope that, down the road, if the SEC does go after the agencies, the agencies will challenge the constitutionality of the rating agency section of Dodd-Frank (which is unconstitutional).

Dodd-Frank is such a mess: (1) it seeks to remove rating agencies from regulations, which is good and returns them to being private sector opinion providers, like Morningstar; and (2) it directs the SEC to regulate the agencies, with all that implies about winks and nudges (not always subtle).
The Europeans have not been subtle about “incorrect” rating opinions. I have always wondered how many NSA-equivalents wiretap and intercept rating agency communications. Not whether, that’s not an issue, but how many.

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