Reading about the Credit Downgrade
Perhaps because I’m not an economist, I can’t at all interest myself in the question of whether the US “deserved” to have its credit rating downgraded (as Standard and Poor’s has done). Kevin Drum says we didn’t deserve it, Ezra Klein says we did, and Jonathan Chait says we did, except not for the reasons that Standard and Poor’s has given. But even to ask that question — it seems to me — is to invest with legitimacy and explanatory power an underlying premise that I do not accept: that a “Nationally recognized statistical rating organization” having such profound power over our government’s economic policy has or could have anything to do with “deserve,” or that there could be a “right” or “wrong” way for them to use their power. I don’t concern myself with that question, because it would be like a death-penalty abolitionist trying to answer whether a murderer deserved to get the chair: whether or not a particular person committed murder is something completely different than whether a murderer deserves to be executed. An opinion on the facts do not dictate a judgement of the moral imperative, nor should they be confused with each other.
After all, it’s obviously the case that our current government is dysfunctional and useless, divided as it is between those who want to destroy government’s social use and those who will not stand up for it. But as Kathy Gill observes, McGraw-Hill owns S&P, and this is who owns McGraw-Hill:
And whether or not McGraw-Hill itself has particular ties with the Bush family — or has a particular interest in driving the politics in this direction — are important questions that I can’t answer, and only point us towards a simpler way of addressing the problem: Standard and Poor’s is a self-interested corporate entity and it is acting in accordance with what it perceives its self-interest to be, in precisely the way that self-interested corporate entities will consistently do. To ask whether a privately owned corporate entity is passing the correct judgment on our political process is to obscure that underlying, anti-democratic fact. They have the power to do so because they’ve been given it: a “Nationally Recognized Statistical Rating Organization” must be “nationally recognized” for its ratings to have the force that it has, and the way the system of financial regulation is constituted is what defines that force. If you’re so inclined, you could even argue that this is all a good thing. God speed to you. As for me, to the secular theology of a “just market,” I am somewhere between a practical agnostic and an angry atheist. The finance market is certainly real and powerful, but the only important question is whether we think the self interest of these kinds of entities is the same as that of the American people, how we will regulate their ability to make decisions, and whether we will continue to cede them the power that they presently have and are using to impose their will on the US’s political economy.
To reiterate the point, the fact that Standard and Poor has the power that it does is not a given thing; it is a decision which was made and which could be un-made. As James Surowiecki wrote in the New Yorker, last year:
[O]ver the years the government has made the agencies an increasingly important part of the financial system. Rating agencies have been around for a century, and their ratings have been used by regulators since the thirties. But in the seventies the S.E.C. dubbed the three biggest agencies—S. & P., Moody’s, and Fitch—Nationally Recognized Statistical Rating Organizations, effectively making them official arbiters of financial soundness. The decision had a certain logic: it was supposed to make it easier for investors to know that the money in their pension or money-market funds was going into safe and secure investments. But the new regulations also turned the agencies from opinion-givers into indispensable gatekeepers. If you want to sell a corporate bond, or package a bunch of mortgages together into a security, you pretty much need a rating from one of the agencies. And though the agencies are private companies, their opinions can effectively have the force of law. The ratings often dictate what institutions like banks, insurance companies, and money-market funds can and can’t do: money-market funds can’t have more than five per cent of their assets in low-rated commercial paper, there are limits on the percentage of non-investment-grade assets that banks can own, and so on.
Rajiv Sethi has a useful post on how these agencies got such visibility and influence (via). And as Robert Reich pointed out, the particular irony of this situation is that the entire debt debate was catalyzed by a financial crash which the credit agencies directly helped cause:
S&P’s intrusion into American politics is also ironic because, as I pointed out recently, much of our current debt is directly or indirectly due to S&P’s failures (along with the failures of the two other major credit-rating agencies — Fitch and Moody’s) to do their jobs before the financial meltdown. Until the eve of the collapse S&P gave triple-A ratings to some of the Street’s riskiest packages of mortgage-backed securities and collateralized debt obligations.
Had S&P done its job and warned investors how much risk Wall Street was taking on, the housing and debt bubbles wouldn’t have become so large – and their bursts wouldn’t have brought down much of the economy. You and I and other taxpayers wouldn’t have had to bail out Wall Street; millions of Americans would now be working now instead of collecting unemployment insurance; the government wouldn’t have had to inject the economy with a massive stimulus to save millions of other jobs; and far more tax revenue would now be pouring into the Treasury from individuals and businesses doing better than they are now.
In other words, had Standard & Poor’s done its job over the last decade, today’s budget deficit would be far smaller and the nation’s future debt wouldn’t look so menacing.
We’d all be better off had S&P done the job it was supposed to do, then. We’ve paid a hefty price for its nonfeasance.
More than that, as Surowiecki pointed out last year,
The rating agencies’ role in inflating the bubble is well known. Less obvious is their role in accelerating the crash. Agencies have typically resisted changing their ratings on a frequent basis, so changes, when they occur, tend to be belated, widespread, and big. In the space of just a few months between late 2007 and mid-2008 (after the housing bubble burst), the agencies collectively downgraded an astonishing $1.9 trillion in mortgage-backed securities: some securities that had carried a AAA rating one day were downgraded to CCC the next. Because many institutional investors are prohibited from owning too many low-rated securities, these downgrades necessarily led to forced selling, magnifying the panic, and prevented other investors from swooping in and buying the distressed debt cheaply. In effect, the current system pushes many big investors to buy high and sell low.
This is also what the Senate report “Wall Street and the Financial Crisis: Anatomy of a Financial Crisis” reported: (via)
Moody’s Investors Service, Inc. (Moody’s) and Standard & Poor’s Financial ServicesLLC (S&P), the two largest credit rating agencies (CRAs) in the United States, issued the AAA ratings that made residential mortgage backed securities (RMBS) and collateralized debt obligations (CDOs) seem like safe investments, helped build an active market for those securities, and then, beginning in July 2007, downgraded the vast majority of those AAA ratings to junk status.953 The July mass downgrades sent the value of mortgage related securities plummeting, precipitated the collapse of the RMBS and CDO secondary markets, and perhaps more than any other single event triggered the financial crisis.
Between 2004 and 2007, taking in increasing revenue from Wall Street firms, Moody’s and S&P issued investment grade credit ratings for the vast majority of the RMBS and CDO securities issued in the United States, deeming them safe investments even though many relied on subprime and other high risk home loans. In late 2006, high risk mortgages began to go delinquent at an alarming rate. Despite signs of a deteriorating mortgage market, Moody’s and S&P continued for six months to issue investment grade ratings for numerous subprime RMBS and CDO securities.
As Jane Hamsher and “Scarecrow” argued a month ago, S&P’s actions are sufficiently weird as to make alternate explanations increasingly plausible; they speculated that (and give evidence for why) there might be a
story-behind-the-story driving S&P’s actions in the debt ceiling debate, which appear inexplicable at face value and go way beyond what Moody’s or Fitch have done. And the more we looked at the timeline of events, the more we wondered how the intertwining dramas of a) S&P downgrade threats, b) the liability that the ratings agencies may have for their role in the 2008 financial meltdown, and c) the GOP’s attempts to insulate the ratings agencies from b) are all impacting each other.
Dean Baker (update, 7/7), “raises the question of whether S&P fears an investigation and possible prosecution,” notes that “[i]n such circumstances the desire to curry favor with powerful politicians could certainly influence their credit rating decisions,” and observes that:
S&P made a big point of citing the fact that the debt deal did almost nothing to slow the growth of Medicare and other entitlements, obviously alluding to Social Security. S&P surely knows that Medicare’s cost growth is driven by projections of explosive growth in private sector health care costs. The projections it relies upon from the Congressional Budget Office show that the cost of providing health care to an average 65 year-old in the private sector will be almost $20,000 (in 2011 dollars) a year by 2030. Of course, this will make Medicare unaffordable if it proves true, but this projected explosion in health care costs will be devastating for the U.S. economy even if we eliminated Medicare and other public sector health care programs altogether.
If S&P were being honest, it would have written about the need to fix the U.S. health care system. Instead it talked about the need to cut Medicare. Of course, if U.S. health care costs were comparable to those in any other country in the world, then we would be looking atmassive surpluses in the long-term, not deficits.
The reference to Social Security also cannot be supported. The program is financed by its own designated tax. Under the law, if benefits exceed the money raised by the tax, then they are not paid. If S&P assumes that Social Security will add to the deficit in future years, then they are assuming that Congress will change the law in a way that no one is now proposing…
In short, there is no coherent explanation that can be given for S&P’s downgrade. This downgrade was not made based on the economics. We can only speculate about the true motive.
And Matt Stoller on Standard and Poor’s predatory agenda (update, 7/7):
In the early 2000s, several states attempted to rein in an increasingly obvious predatory mortgage lending wave. These laws, pushed by consumer advocates, would have threatened the highly profitable mortgage securitization pipeline. S&P used its power to destroy this threat. Josh Rosner and Gretchen Morgenson told the story in Reckless Endangerment:
“Standard & Poor’s was the most aggressive of the three agencies, however. And on January 16, 2003, four days after the Georgia General Assembly convened, it dropped a bombshell. Because of the state’s new Fair Lending Act, S&P said that it would no longer allow mortgage loans originated in Georgia to be placed in mortgage securities that it rated. Moody’s and Fitch soon followed with similar warnings.
It was a critical blow. S&P’s move meant Georgia lenders would have no access to the securitization money machine; they would either have to keep the loans they made on their own books, or sell them one by one to other institutions. In turn, they made it clear to the public that there would be fewer mortgages funded, dashing “the dream” of homeownership.
It was an untenable situation for the lenders who had grown addicted to the securitization money spigot. With S&P shutting it off to abusive lenders, it was only a matter of time before the Fair Lending Act was dead…”
This is far from the only time S&P has thrown its weight around to advance its financial interests. My favorite story about S&P is how its parent company, publisher McGraw-Hill, tried to cancel Barry Ritholz’s book because he wrote unfavorably about the ratings agencies. When I was on Capitol hill, I actually brought this story up to an S&P lobbyist. She told me about how Ritholz got his facts wrong, that the company has a Chinese wall between the ratings agency and the publisher, and that, besides, he was just a blogger. That’s S&P for you.
Whether there’s any there, there (and I would be shocked, shocked, to find political corruption on Wall Street), lots of people are certainly noting that S&P’s logic is strikingly bad. Paul Krugman charged, Friday, that they are “just making stuff up”:
[I]t turns out that S&P got the math wrong by $2 trillion, and after much discussion conceded the point — then went ahead with the downgrade. More than that, everything I’ve heard about S&P’s demands suggests that it’s talking nonsense about the US fiscal situation. The agency has suggested that the downgrade depended on the size of agreed deficit reduction over the next decade, with $4 trillion apparently the magic number. Yet US solvency depends hardly at all on what happens in the near or even medium term: an extra trillion in debt adds only a fraction of a percent of GDP to future interest costs, so a couple of trillion more or less barely signifies in the long term. What matters is the longer-term prospect, which in turn mainly depends on health care costs.
So what was S&P even talking about? Presumably they had some theory that restraint now is an indicator of the future — but there’s no good reason to believe that theory, and for sure S&P has no authority to make that kind of vague political judgment.
And follows up today (updated, 7/7):
The point here is not so much the $2 trillion, which makes very little difference to real US fiscal prospects; it’s the fact that S&P stands revealed as not understanding basic analysis of budget estimates. I mean, I don’t think I would have made that mistake; real budget experts, like the people at theCenter on Budget and Policy Priorities, certainly wouldn’t have.
So what we just saw was amateur hour. And these people are pronouncing on US credit-worthiness?
Where does all that put us? Well, Yves Smith suggests the impact might not be as huge as it seems, comparing it to Y2K:
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.”
James Kwak makes a similar argument:
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 theTimes 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.
and adds that “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 tranch 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.
Anyway, Juan Cole argues that it is all basically reducible to inequality:
Standard & Poor is saying that if you project out the US structural deficit– caused mainly by the Bush tax cuts, prescription drugs give-away and debt-financed wars–over the next ten or fifteen years, it is going to get worse and worse because rich people have started refusing to pay their taxes in the US. There is a long-term structural deficit that the Republicans in Congress are refusing to allow the country to redress. In short, they are talking about this chart, which I posted last week:
It would not take a large tax hike on the wealthy to fix the problem. Bill Clinton did it in the early 1990s. People who say that this step would not resolve the difficulty are shills for the super-rich and are refuted by the successfully balanced budgets of the late Clinton period.
People who say that the rich ‘create jobs’ and that taxing them would hurt the economy have to explain why corporations are making record profits but the rest of the population is increasingly living on food stamps.
What I read in economics was that it is bad for the economy to have a high gini coefficient, i.e. it is bad to have a big gap between a handful of wealthy at the top and great masses of poor at the bottom. It is much better if there is a big middle class and the rich aren’t so very rich.
Why is this the case? Well, you would want everyone who wanted one to be able to buy a car from Detroit. When people buy a Chevy Volt, that creates jobs at GM, and it creates demand for spare parts, which creates more jobs, and it creates jobs for car salesmen and for the people who make the battery, etc., etc. The real job creators are us ordinary folks, the consumers; we create jobs when we buy goods and services.
So if there are roughly 75 million families in the United States, you’d like them all to be able to buy a Chevy Volt if they wanted one. But if you reduce them to living on food stamps (as 40 million people now do), then they can’t buy a new car, even on credit. Now you’ve set up your tax policy to throw trillions into the hands of 3 million people or 750,000 families. But how many cars are those families going to buy? Even if each had a fleet of ten, that would be as though 7.5 million families each bought one. It can’t compare to having 75 million families each buy one.
Richard Seymour’s account of the class politics of it:
Making it more difficult to repay debts while demanding that the government repay its debts faster is only a reasonable step if you accept that finance capital can do whatever the bloody hell it likes. During the New York City fiscal crisis in the 1970s, created because lenders refused to roll over debts, a director at the NY State Emergency Financial Control Board pithily explained: “The demands of the lender become reasonable because the lender is the lender.” A poignant reminder that behind every rationality lies a sociology. Of course the hedge funds, ratings agencies, banks etc are less than concerned about the effect of underfunded infrastructures such as health and higher education. As far as they’re concerned, spending is too high and they don’t much care how it comes down. Theirs is a very narrow perspective. But why doesn’t the Wall Street establishment seem overly concerned that ‘fiscal consolidation’ of this kind will compound the fragility of the US economy and possibly tip the world into a new recession-cum-depression?
The pathologies of the US economy are not exactly a secret. Michael Perelman identifies the following as weaknesses of US capitalism in its neoliberal phase: long-term underinvestment in research and development, low productivity resulting from a shift toward low wage service jobs, more financial vs productive investment, underinvestment in infrastructure, and an irrational military Keynesianism that results in the best innovation and research being conducted in secrecy, hoarded by the Pentagon etc.. Obama has performed sterling work on behalf of the Wall Street establishment, throwing his immense clout behind the bail outs, screening them from criticism, allowing them to continue to act with relatively little serious oversight, bringing them into government decision-making, and basically devising most of his policies with an eye to pleasing investment banks, bond traders and, at the outside, hedge funds. But what he doesn’t done is re-orient US capitalism in a more rational direction. What he doesn’t done is anything that could conceivably rescue the system from its pathologies.
Finally, Ben suggests a flash mob. I’m in:
[F[or now a serious suggestion: let’s get 500 people or so and just take up space at the Standard + Poor office building on Monday. Maybe the lobby, maybe just the entrances, wherever it would create the biggest hassle. It won’t stop them from doing anything and ultimately it will just be a minor inconvenience for them, but it will make us feel really good for having screwed up a part of their day.
I suggest this because it is exactly analogous to the downgrade they just issued on US debt, and so would be a very very small sliver of the karmic justice that is due these slimeballs. Standard + Poor made a political decision. They looked at the US political system, didn’t like what they saw, and used the levers available to them to try and affect it. They did so haphazardly and despite known flaws in their analysis.