According to Standard & Poor's, the USA is no longer worthy of a ‘AAA' sovereign debt rating. Novatis Asset Management's Frank Dolan asks, so what?
S&P has downgraded the USA's credit worthiness to ‘AA+'. That's on a par with Belgium, a notch above Chile (‘AA') and one below us (UK - ‘AAA').
The ratings agency on its website (www.standardandpoors.com) states:
"An obligation rated ‘AAA' has the highest rating assigned by Standard & Poor's. The obligor's capacity to meet its financial commitment on the obligation is extremely strong."
"An obligation rated ‘AA' differs from the highest-rated obligations only to a small degree. The obligor's capacity to meet its financial commitment on the obligation is very strong."
There is little difference between a ‘AAA' and a ‘AA+' rating and it is unlikely the downgrading of the US will have a significant impact on the banking community.
None the less, it is worth looking at the "so what?" question in more detail.
From an ordinary investor's perspective, the sovereign debt of the US, UK, France, Germany and so on would be considered "safe". But it is not the ordinary investor's opinion that counts here. It's the ratings agencies.
In the 1970s, ratings agencies started charging issuers for making independent assessments of investments. The US government was concerned this could lead to unscrupulous agencies setting up and so in 1975 appointed S&P, Moody's and Fitch as the only agencies banks and brokers could use to assess creditworthiness.
The Securities and Exchange Commission (SEC) has since approved a further 7, making a total of 10 "National Recognized Statistical Ratings Organizations" [sic] or NRSROs.
Since then, the 2004 Basel II rules have put credit ratings central to the process of working out how much capital a bank had to hold in reserves but at a time when sovereign debt was considered risk free.
As a result, many of the world's major banks hold large quantities of sovereign debt as capital reserves.
Now, with downgrading becoming a seemingly regular event, banks are being forced to re-evaluate and it is this re-evaluation that is putting additional strain on the banking system.
The position is worse under Basel III with the importance of credit ratings for bond portfolios being further enhanced.
There are efforts underway to find an alternative solution but for now, despite their real and/or perceived flaws, the ratings agencies are all that is officially available.
So, perhaps the greater significance of the US downgrade is in two parts.
The first is that this could trigger a re-evaluation of other sovereign nations such as the UK, France, Germany etc. with the consequent possibility that they could also be downgraded.
The second is that a further re-evaluation of the US's new rating, accompanied by (or on the heels of) some other ‘high profile' downgrades could lead to a ‘downgrade spiral' when the repercussions could be much more serious.
S&P has already said, in reference to the USA:
"We could lower the long-term rating to ‘AA' within the next two years if we see that less reduction in spending than agreed to, higher interest rates, or new fiscal pressures during the period result in a higher general government debt trajectory than we currently assume in our bad case."
In truth we cannot ignore these ratings because they are now embedded in the regulations that dictate how banks, many pension and other funds operate.
No matter how flawed their judgments might prove to be, the NRSROs have a major role in the world financial system - but this power needs to be curtailed.
As we have already seen to our collective cost in the case of CDOs, the ratings agencies are fallible.
Even if that weakness does not permeate into sovereign ratings, the continuing importance attached by bond investors to the judgment of a few agencies, instead of relying on their own analysis and judgment, is likely to cause us all further problems.
Now is most definitely a time when change is needed to diminish the power of the rating agencies.
If that can be achieved, announcements such as S&P's downgrade of the US may justifiably be accompanied by a chorus of "so what?".
Three years at Wells Fargo
Effective from 9 December 2019
One firm with permission suspensions left
Continuing the Architas education series for clients.
Needs to apply for authorisation