So What? Part Two

So, Standard and Poor’s went ahead and downgraded the United States yesterday, apparently because we have a dysfunctional political system. Who knew?

As I said before, I don’t think that S&P has added anything new to the world’s stock of information. In the short term, the most worrying thing about a downgrade is what I called the “legal-mechanical consequences”: the possibility that investors, who value their own opinions more than S&P’s anyway, might have to dump Treasuries because they are no longer AAA. Apparently, this is not going be a huge problem. Binyamin Appelbaum of the Times says that (a) many of the rules place Treasuries in a different category from other AAA securities to begin with and (b) since the downgrade only affects long-term debt, money-market mutual funds are safe.

Still, I think the whole thing is preposterous. S&P downgrading the United States is like Consumer Reports downgrading Coca-Cola. Consumer Reports is a great institution. For example, if you want to know how reliable a 2007 Ford Explorer is going to be, they have done more research than anyone to figure out the reliability history of every single vehicle. Those ratings are a real public service, since they add information to the world. But when it comes to Coke and Pepsi, everyone has an opinion already, and no one cares which one, according to Consumer Reports, “really” tastes better. When S&P rated some tranche of a CDO AAA back in 2006, it meant that some poor analyst had run some model fed to her by an investment bank and made sure that the rows and columns added up correctly, and the default probability percentage at the end was below some threshold. It might have been crappy information, but it was new information. When S&P rates long-term Treasuries AA+, it means . . . nothing. And if any serious buy-side investor were tempted to take S&P’s rating into account, she would be deterred by the fact that the analysis that produced the rating included a $2 trillion arithmetic error.

When it comes to sovereign debt issued by major countries, investors already use their own judgment instead of following credit ratings. These are the current ten-year yields for fifteen countries that had AAA ratings on Friday:

  • Switzerland: 1.17
  • Singapore: 1.79
  • Germany: 2.34
  • Sweden: 2.34
  • United States: 2.56
  • Denmark: 2.58
  • Canada: 2.63
  • Norway: 2.63
  • United Kingdom: 2.68
  • Netherlands: 2.77
  • Finland: 2.90
  • Austria: 2.97
  • France: 3.14
  • New Zealand: 4.50
  • Australia: 4.64

(Data from Bloomberg: I couldn’t find Liechtenstein or Luxembourg.) That’s a pretty big spread for fifteen securities that are supposedly equally risk-free. Part of the difference is probably due to inflation rates, but higher inflation expectations should affect sovereign credit ratings anyway, since inflation is the most likely escape hatch for any country that issues debt in its own currency. You see the same disparities for 5-year credit default swap spreads, from Switzerland at 35 basis points to France at 144 (with the United States at 55).

Felix Salmon says that the United States doesn’t deserve a AAA rating anyway, and when a significant minority of Congress (with disproportionate political power) actually wants to default on the debt, it’s hard to argue with him. But I don’t see what point there is in credit rating agencies rating Treasury debt when it doesn’t help investors and can only create confusion and increase borrowing costs through mechanical factors. Instead, I think S&P should have just said:

“We have decided to no longer rate sovereign debt issued by the United States, Germany, the United Kingdom, Japan, and other countries whose debt is closely followed by all major investors already and for which underlying fundamental information is widely available. We recognize that our opinion is no better than anyone else’s, and certainly no better than that of the market as a whole, but because of our status as a credit rating agency, it cannot help attracting attention it does not deserve and triggering consequences it does not merit. We will focus on our core mission, which is providing new information to the market about securities that are not already heavily analyzed by all the investment community.”

Update: A friend who knows these things better than says that falling Treasury prices, by forcing investment banks and other borrowers in the repo market to put up more collateral, could force some institutions to deleverage.

This post originally appeared at The Baseline Scenario and is reproduced here with permission.