Remember Y2K? The world was gonna end because there was tons of legacy code that couldn’t accommodate the rollover to the new century. I know people in who went into survivalist mode, stocking up months of supplies, and others who took less extreme precautions, like having lots of cash on hand in case ATMs were disrupted.
As we now know, January 1, 2000 came in without major incident, since the widespread publication of this software threat to End the World as We Know It led to lots of preventive action. Perversely, the big effect of the Y2K scare was that it accelerated tech spending, since many firms bought new systems and upgraded hardware as part of their overhaul. That increased the severity of the post-bubble economic downturn. Remember, Greenspan dropped Fed fund rates to negative real interest rate levels and held them there for an unprecedented amount of time, which many argue helped stoke the housing bubble. So while Y2K’s direct effects were greatly overestimated, its indirect impact (on how long the former Maestro kept rates down) may not have been fully acknowledged.
It isn’t yet clear what the impact of the S&P downgrade of the US to AA+ will have. There are good reasons to believe, despite the media hyperventilating, that it won’t add up to much, and may perversely hit wobbly stock markets more than Treasury yields.
But there is a much bigger issue, namely S&P’s highly questionable conduct, the lack of any analytical process behind this ratings action, and the political implications.
Will the S&P Downgrade Have Much Immediate Impact?
Although I run the risk of being proven wrong, there are lots of reasons to think that the reaction in the Treasury market to the news will be underwhelming. We might see some reactions Monday as some investors who managed to be blindsided and aren’t happy with the downgrade exit but conversely, I know of investors who see any price softening as a buying opportunity.
Treasury yields fell 50 basis points last week despite the risk of a downgrade being very well telegraphed. S&P had asked for $4 trillion in deficit reductions (it tried disavowing that number) and made it clear it was going off to brood and might take action. And this market response took place with S&P leaking like a sieve. Not only was Twitter alight early on Friday with rumors of the downgrade, but some parties purportedly got the memo earlier in the week. From a credible source via e-mail:
Good friend passed on a note from a hedge-funder who thinks the S&P not only fudged its figures for today’s downgrade, but leaked it in-advance earlier this week to a few hedge fund insiders who made a killing off it. That would square with the fake “states face bankruptcy” panic scam earlier this year, which made a few people a lot of fast money.
I assume they did not make a directional bet but went long vol.
So what if bond yields go up 50 basis points on Monday, which is normally a monster move? It just puts us back to where we were last Monday.
So why didn’t investors dump Treasuries with this threat hanging over the market’s head? Maybe investors have wised up and realize the ratings are worthless (more on that shortly). Here is a partial list of reasons:
Investors that are required to hold AAA paper can continue to rely on the AAA ratings from Moody’s and Fitch. Two ratings will suffice for virtually all users (and there were media reports of various regulated investors seeking opinions and getting waivers if they thought they might need them). In case there were any doubts, the Fed, Treasury, FDIC, NCUA and OCC told S&P to go to hell and issued a press release saying that the entities they regulated to carry on as before. Bloomberg, which provided a comparatively sanguine account, noted:
“Yields are low in the face of a downgrade because there is nowhere else for people to go if they don’t buy Treasuries because they want to be in safe dollar assets,” Carl Lantz, head of interest-rate strategy at Credit Suisse Group AG, one of 20 primary dealers that trade directly with the Fed, said before the announcement.
Investors may not be thrilled with the dollar, but the Eurozone is facing existential stresses, the yen and Swiss franc are in nosebleed territory, the yuan has capital controls (the Chinese do not want inflation stoking hot money inflows right now, thank you very much) and major investors see most minor currencies as speculative plays rather than stores of value. The greenback still fares pretty well in the beauty contest among Cinderella’s ugly sisters.
Finally, in a lot of markets, like repo (which serves as collateral for derivatives positions) there aren’t good alternatives to Treasuries.
Why the S&P Downgrade Stinks to High Heaven
There is plenty of well deserved derision on the Internet over the downgrade. Be sure to see #StandardandPoorsThroughoutHistory. IIlustrative: ‘Oh, I think eating the apple would be fine’.
Everyone remembers how the bond graders covered themselves with glory in the housing bubble. The sad thing is that prior to the early 1990s, the nationally recognized statistical ratings organizations were quiet, cautious, respectable, and made their dough rating corporate bonds, which they did competently based on clearly articulated standards (their muni businesses were more of a backwater). They did tend to be slow to downgrade, but everyone in the market knew that and acted accordingly.
The structured credit business ruined the agencies. Their processes became opaque and inconsistent. Would anyone have trusted their assessments had they known that rating agencies ignored basic credit ratios that had been widely used by banks for decades? Reader MBS Guy writes:
The black box issue for securitization is one of the things Dodd-Frank and the SEC (who’ve recently issued new NRSRO proposed regs) are focused on fixing. For MBS, S&P made its mortgage model available for purchase (and many people owned it), but all it did was spit out the numbers for the credit enhancement. It didn’t explain what the model was based on (nothing, as it turned out). For instance, as has been documented in various places, they never explained what their assumptions were for home price movements or GDP and they didn’t provide (or do?) any analysis of what borrower debt to income or LTV did, historically to borrower performance.
The biggest proof of criminal incompetence was their downgrades of RMBS versus CDOs made pretty much entirely of the same RMBS. They started downgrading RMBS en masse in July 2007. They didn’t start marking down CDOs until six month later, and the process took another six months. Yet it should have been impossible to downgrade the RMBS and not the CDOs at the same time. The downgrades were based on the failures of the underlying loans. You can’t have it show up in one product and not the other.
And S&P continues to screw up MBS ratings in the wake of heightened scrutiny. Its latest embarrassing reversal came on August 1. And the week prior, last week S&P messed up the CMBS market by changing the criteria for a deal after it had priced but before it closed.
With RMBS and CDOs, it was hard to see that the emperor was wearing no clothes, thanks to the complexity of the instruments, but it’s blindingly obvious here. Upstart rating agency Egan Jones at least goes through the motions of having a methodology (see its use of metrics). But this is silly for a fiat currency issuer. A country that controls its currency can always satisfy the IOUs it creates. The risk is inflation, not default. But ratings agencies assess credit ratings, not interest rate risk. Japan was downgraded to single A, yet that did not affect its ability to sell bonds at very low yields.
S&P has published criteria for sovereign ratings, but they are still vague and inconsistently applied. And no wonder. They aren’t paid to provide these ratings, and accordingly understaff the activity. Housing Wire quoted recent Congressional testimony by James Kroll:
At S&P, for instance, 100 analysts rate debt for 136 countries – a lot of responsibility, Kroll said, for an organization that failed to recognize the collapse of the mortgage-backed securities market.
“They wield all sorts of power. They can put ratings on entire sovereign countries, and with no liability,” Kroll told the subcommittee. “I don’t think CRAs have the wherewithall, the intelligence range, or the experience to be doing ratings on hundreds of countries around the world. I question if this is the job for the private sector.”
If you look at the S&P statement, it’s not a ratings judgment, it’s a long form political op ed. I suppose I should not be surprised, since the NRSRO’s “get out of liability free” card is that their ratings are mere journalistic opionion. As Robert Reich tartly observed:
If we pay our bills, we’re a good credit risk. If we don’t, or aren’t likely to, we’re a bad credit risk. When, how, and by how much we bring down the long term debt — or, more accurately, the ratio of debt to GDP — is none of S&P’s business.
Jane Hamsher highlights the hypocrisy of the S&P rating, since it shifted from its 2010 rationale of demographic stress to a February 2011 focus on entitlements. And it didn’t bat an eye at the $2.6 trillion deficit-increasing Bush tax cut extension at year end 2010. More from Hamsher:
Neither Moody’s nor Fitch downgraded US debt at this time. And S&P can’t quite come up with a consistent answer about why they are out there by themselves. It’s like they looked at a public opinion poll, decided that there was no way anyone would argue with “partisan bickering” as a justification, and crossed their fingers that nobody would actually question what it is that they were justifying.
S&P is playing footsie with the Republicans, who are passing bills to relieve them of the legal liabilities that Dodd-Frank exposes them to — even as the SEC is investigating S&P for fraud in the mortgage meltdown.
Some said that S&P wouldn’t dare downgrade the US debt. But it was all over four days ago when Pimco’s Mohammed El-Erian said that S&P was “under pressure” on the US rating.
If you didn’t happen to catch Devan Sharma’s testimony before the House Financial Services Committee last week, this was what he said:
As Dodd-Frank rulemaking progresses, we believe it is critical that new regulations preserve the ability of NRSROs to make their own analytical decisions without fear that those decisions will be later second-guessed if the future does not turn out to be as anticipate or that in publishing a potential controversial view, they will expose themselves to regulatory retaliation.
Pressures of that sort could only undermine the significant progress we believe has been made over the years by rating agencies and regulators alike to provide the market with transparent, quality and generally independent views about the credit-worthiness of issuers and their securities. I thank you for the opportunity to participate in the hearing and I would be happy to answer any questions you may have.
That’s what Rep. Randy Neugebauer, chairman of the House Financial Services Subcommittee said on April 29, when he requested documents from the administration: Treasury officials “may have exerted too much pressure on S&P.” The Republicans were already laying the tracks for S&P’s defense in April.
Here are a few more dots to connect the timeline:
April 18: Mitt Romney: “The Obama presidency was downgraded today.”
April 20: Mitt Romney: “Standard & Poor’s, one of the rating agencies, just downgraded their view of the future for America…If you will, they downgraded the Obama presidency.”
July 15: WSJ — “The Obama downgrade.”
They’ve been cooking this one for a while. S&P will defend themselves from the accusation of overt partisan manipulation by claiming the Treasury “pressured” them not to downgrade US debt. The media will focus on what Geithner did or didn’t say during his meetings with S&P in March and April. Nobody will ask about the ridiculous excuses S&P has made for the downgrades, or the fact that they are trying to wreck the American economy just as they did the British economy by playing God with their austerity prescriptions.
People are focused on the market implications of the downgrade, but that isn’t what this is about. It’s about a President who will now be relentlessly tagged with responsibility for a rating given by a disgraced organization whose victims should have liquidated them long ago.
As Politico reported, White House officials feared a downgrade more than they feared default. They know what it means, too. The Masters of the Universe have spoken.
Yves again. Sell on News at MacroBusiness elaborates on the issue that Hamsher and Reich highlighted, which is that this ratings action is really a power struggle over who wields authority:
Who exactly are these ratings agencies? Oh, those corrupted, easily deluded companies who are to sane analysis what a croupier at a roulette table is to an insurance policy. They showed in the lead up to the GFC that they go to the highest bidder and that they have little or no credibility. Suddenly these private companies have authority over the US government? And then let’s look at what happens to demand for US dollars if there is a downgrading. Nothing. The $1-2 trillion that they are arguing about is about six hours trading in the greenback. The US dollar is the world’s reserve currency and will be for some time….
They are nevertheless a symptom of a much deeper, long term issue — the replacement of the nation state with the market state…
There has been no real leadership about what the system should look like and what is government’s role in it. Yet these fundamental questions must be answered because those who believe markets should rule do not think governments have any role at all (other than to bail them out when the markets fail). They operate under the Ayn Rand delusion that people who make money are the true creators, the Atlases who impel the world, while everyone else is just an evil taker, sucking from the system.
This is nonsense. Not only does government have to set the rules that determine the frameworks of markets, in the case of the monetary system, which consists of rules, they are, by necessity, the only final point of reference (literally where the buck stops). Ratings agencies cannot be that, they are just another private player and an easily corrupted one at that.
So to try to remove government from the financial markets, as the market worshipers wish to do, is to set out to destroy the system itself (something the GFC almost achieved). When people are allowed to invent the rules of money themselves, make money from their invention of new forms of money that exploit the rules of the system, self organisation may work for a while — the competing self interests will for a time balance out — but eventually it will just collapse, as we saw in 2008. Making up new rules of money can be infinite, wealth creation cannot. It must have limits. Hence the necessity of the state’s role.
Just as the Y2K threat was overstated but nevertheless had unexpected, adverse intermediate term consequences, I doubt this chicanery will be cost free to the public at large. But the debt overhang that ideologues have used to whip the public into a funk is profoundly deflationary unless addressed head on, via writedowns and bankruptcies offset by fiscal stimulus. Deflation means that high quality bonds are the place to be, as the market action of last week confirmed, so Treasuries benefit from the very condition that S&P depicts as a disaster.
Thus the best outcome would be if the bond and currency markets shrug off the S&P action, which would reveal that the much feared downgrade was a paper tiger. But even if the marker response is underwhelming, it is hard to imagine that Obama will not take a political toll for his colossal miscalculation. It was he who stoked the debt ceiling phony crisis to implement a neoliberal agenda, who refused to reverse course and threaten to circumvent the debt limits when the process had clearly spun out of his control.
So even if S&P fails to land a body blow in the markets, its ploy has garnered press that seems certain to taint the Administration, and thus confirms the power of its reckless conduct. Thus the cost is not likely to show up in bond yields, but in something far more fundamental: in yet more destruction of the foundations of our society for short-term, selfish ends.