Investor Guide to the US Debt Downgrade

The question on the minds of most investors?  What to make of the S&P downgrade of US debt?

There are many of opinions and plenty of finger pointing.  Step back.  Take a deep breath.  Follow along with me as we consider this from three different perspectives --  public policy, political, and market.

It is important to consider all three perspectives.  Many observers are confusing these.

The US Policymaking Process-- Background

Policymaking in the US reflects the concept of pluralism. The process empowers many different groups who often can veto or block changes.  The resulting decisions reflect a centrist policy.  It has worked pretty well for over 200 years.

Market Punditry

Market pundits do not like this.  They want to see a clean and efficient solution -- and one that agrees with their own personal choices!

Any process that does not deliver this outcome is wrong.  Let us apply this to the debt ceiling debate.

For starters, this should not have been on the agenda.  Those in Congress who want to challenge the budget deficit should do so via the appropriations process, the taxation process, or the budget process.  Doing it at a time when it can raise apparent questions about US creditworthiness was irresponsible.

Our political process allows people to behave in irresponsible ways.  This was not the first time, nor will it be the last.  Once the issue is in play, what should we expect?

• The Tea Party took one extreme, unwilling to vote for any increase in the debt limit without various impossible conditions.

• The liberal wing of the Democratic party took another extreme, unwilling to compromise on any program including cuts to favored spending programs.

• Moderates in both parties found a central ground and  the debt extension was passed -- something that was completely predictable, as I repeatedly noted.

So the pundits, led by the dimwits at the S&P rating group, don't like this process.  They think that it raises the possibility of a future default.

This is completely wrong.  It demonstrates the lack of understanding by the S&P and by many pundits.

We have a political process that permits extreme viewpoints to have a voice.

If you don't like this, take it up with James Madison!

Policy Implications

Let us be clear about the issues.  Addressing the deficit means deciding things like the following:

• Entitlement spending
• The age of retirement and eligibility for Medicare
• Defense spending
• The level of taxation -- and who should pay
• How fast should we address the problem ?
• Should we cut spending and related jobs with the economy on shaky ground?

And many more.

Who should make these decisions?  Should it be done by  our elected officials?  Something using the checks and balances from our Constitution?

No matter what you think about the questions, you should have an opinion about who should decide.  Should it be the S&P rating committee?  Who elected them?

The obvious policy implication is for the US to strip some official authority from the ratings agencies.  They might be needed to help investors assess muni bonds, but they are not needed for US sovereign debt.

The value of these agencies was already in doubt after the blunders of Enron, Worldcom, and the AAA ratings accorded to various synthetic mortgage obligations.  S&P seems to be on a suicide mission here -- a race to be as irrelevant as possible.

The S&P decision seems to reflect a verdict on our governmental process as well as the decision.  It is a poorly-timed, tone deaf verdict, rendered despite  their acknowledged error in calculating the long-term debt ratio.

Not the least of the embarrassments is the empowerment of the Chinese.  While I do not expect the Chinese to sell US debt, the S&P has empowered them to recommend a cut in our defense budget!!  

Political Implications

This will be a huge sideshow.  I am writing this before the morning talk shows where each party will blame the other.  One of the biggest challenges for investors is to put aside the political commentary (despite our own strongly-held opinions) and think only about investments.

My early line is that the GOP will score by blaming Obama for presiding over a downgrade.  I get commentary from friends of all persuasions.  The liberals think that Obama sold out.  If he had  done what they wanted, we would have had a downgrade from all three agencies.  My conservative friends can't believe that we don't have a balanced budget amendment.

Market Implications

Everyone wants to know what this will do to the market.  My own estimate (check out what I predicted last week) is that the effect will be modest.  Here are the reasons:

• No one buying US Treasuries depends on these ratings.
• There are three agencies.  The other two are smarter than the S&P.
• Those who have covenants requiring a AAA rating often base it on two agencies.  Those that do not have this provision will soon change the requirements.
• The biggest effect will come from psychology -- not from actual bond trading.

Monday trading will be complicated, since the Europe story will compete with the S&P downgrade.

A Final Thought

My final verdict is that this decision is more relevant for the S&P ratings group than for the US.  It is a bad decision that will diminish respect for the agency.  They took an extreme viewpoint.  They indulged in politics.  They poured gasoline on a fragile market.

 

Comments

[oldprof]

Hi Angel --

Try the Koo citations in this article:

http://www.businessinsider.com/reinhart-and-rogoff-dangerous-debt-ceiling-2011-8#comment-4e381581eab8ea7a6d00001e

I think that is where I saw it originally.

Thanks for helping to research this.

Jeff

[Angel Martin]

Jeff, I am still looking for a reference for the 90% debt as an almost certain point of no return for eventual default. I don't believe it is in the Rogoff &Reinhardt "Debt reduces economic growth" paper. so i will have to go back to the book.

[oldprof]

Proteus -- Judging from the comments both here and on Seeking Alpha, you are well in the majority.

Everyone thinks that the S&P is conveying a righteous message. I am listening, and I'll follow up.

Thanks for another typically constructive and helpful comment.

Jeff

[oldprof]

Reacher -- I think you are looking too deeply into possible motives.

Meanwhile, I just finished '61 Hours' and I am worried about your apparent death!

Is everything OK?

Jeff

[oldprof]

Hi Angel -- Concerning the 90% debt level - I read something that suggested that this was a tipping point for countries where interest rates were spiking, but not those with low rates.

This has some plausibility. It has been a hectic week and I cannot find the reference. I know that you are an excellent and open-minded researcher, so perhaps you will take a look.

I am sure that you know that there is a world view surrounding the Rogoff work, so this is a major point.

Thanks,

Jeff

[Proteus]

Jeff, it seems like more blog pages and comments have appeared on this topic than on the big market declines. Somewhat surprising.

I disagree with your comment about "Who elected S&P?", although I seem to be very much in the minority. I see nothing wrong with them voicing an opinion about steps needed to improve the US rating. I would feel the same way about other countries or individual companies. Should their being right or wrong in the past (on CDOs) be relevant to whether they are right or wrong now?

As for my own investing, one year ago I would have stated the probability of a US default was "zero". I would now reluctantly say it is still zero, but with a small asterisk.

[Angel Martin]

Jeff, I looked at Schiller's article and I still disagree with you and Schiller. Points:
-the structural deficit in the BIS article is claimed to be a "cyclically adjusted balance" so I don't think it is correct to state that it is projecting from the worst point in the cycle.
-Schiller references the Rogoff study but leaves out what I think is the most important finding, which is that countries that exceed the 90% debt threshold almost always go on to default via massive inflation or direct debt repudiation
-Schiller can change the denominator of the debt ratio if he wants to, but 90% debt to annual gdp (or 9% of decade gdp) has proven over 800 years to be an important tipping point that investors should not ignore.
-Jeff, "going for growth" and not worrying about debt or inflation was what UK politicians in both parties thought they doing in the 60's and 70's. It didn't really work in the short term and was disastrous in the long term
-what is frustrating to me about all this is that on a P/E and interest rate basis, the S&P offers almost unprecedented value. All of the worst risks to the market come from the government/political sector whether it's sovereign debt or the stability of the euro. If the public sector was not so screwed up, i believe the economy and market would take off like a rocket.

Angel

[Jack Reacher]

Not sure Obama didn't want to "empower the Chinese". Allinsky would. Also, how irresponsible for him to mention no SS checks, and the "threat of possible US default"?

Some leader.

But Jeff, thank you so much for this analysis. I read your work first. And again last. Thanks.

jr

[oldprof]

Angel --Three ideas in response to your thoughtful comment.

1) I have written many times about the long-term need to deal with the fiscal imbalance. There is a link at the top of this blog. It is an issue that is best dealt with right AFTER an election and with the deficit reduction commission proposals in hand. There will be entitlement cuts and increased revenue.

2) The chance of default was over-estimated by the media. The bond market did not expect it. If you listened carefully to Congressional leaders, as I did for weeks, it was obvious that there would be a solution. Only the final definition was in doubt.

3) The problem with your structural deficit analysis is that it is based on projecting our economy at the worst point, and assumes no policy changes. The S&P is wrong to demand that this problem be addressed RIGHT NOW.

I planned to use this quote from Robert Shiller in the weekly article (and may still do so) but take a look. Please read the entire article, which provides an excellent perspective. http://www.project-syndicate.org/commentary/shiller78/English

"The fundamental problem that much of the world faces today is that investors are overreacting to debt-to-GDP ratios, fearful of some magic threshold, and demanding fiscal-austerity programs too soon. They are asking governments to cut expenditure while their economies are still vulnerable. Households are running scared, so they cut expenditures as well, and businesses are being dissuaded from borrowing to finance capital expenditures.

The lesson is simple: We should worry less about debt ratios and thresholds, and more about our inability to see these indicators for the artificial – and often irrelevant – constructs that they are."

The point is that our focus should be on restoring economic growth. The ill-timed debt debate is making the problem harder to solve.

Jeff

[Angel Martin]

Jeff, I really disagree with the public policy analysis put forward in this article.

The definition of AAA bond is "An obligor rated 'AAA' has EXTREMELY STRONG capacity to meet its financial commitments."
http://www.bankersalmanac.com/addcon/infobank/credit_ratings/standardandpoors.aspx

Frankly, if the political process surrounding the debt ceiling can put US creditworthiness at risk, it by definition does not have an "EXTREMELY STRONG capacity to meet its financial commitments."... and shouldn't be rated triple AAA.

Beyond that, the fundamentals of the structural deficit (USA: 8% of GDP for 2011) and the future costs of the retirement programs as reflected in the baseline scenario (table 1 and graph 4)
http://www.bis.org/publ/work300.pdf?noframes=1
also suggest that the US should not be rated AAA. And neither should any of those other countries in graph 4. If they really were AAA, they would be solvent under the baseline scenario, and none of them are.

As it is, future solvency is likely only if the political process in these countries can deliver major policy changes that will have a lot of opposition. Any sovereign that is depending on politically uncertain future policy changes cannot honestly be rated as having an "EXTREMELY STRONG capacity to meet its financial commitments."

Based on the above, I think S&P is completely justified in the downgrade - frankly it was long overdue.