The big U.S. downgrade: Folly or foresighted?

It was just a weekend ago when Standard & Poor’s, the U.S. ratings firm, rattled the world by downgrading America’s Treasury securities by one notch from AAA to AA+.

It was three years ago when Kevin Rudd, the then prime minister of Australia declared to Bloomberg News: “The ratings agencies will pay.” Rudd thought the raters would be called to account for the largest blunder in financial history, when American raters S&P, Moody’s and Fitch stamped AAA on half-a-trillion dollars of sub-prime debt, only to downgrade it to junk as it collapsed.

Rudd’s Australian government, like many others, got stuck with the junk. Hundreds of politicians, pension managers and investment officials around the world expected U.S. regulators and courts would punish the agencies harshly with fines, penalties and tight regulation and orders to pay back.

So far, it’s been the opposite.

The S&P downgrade of U.S. government securities on August 8 shows the raters are back in business more than ever – right or wrong. Supporters cheered the recent downgrade decision, praising the agency’s courage to take on the Obama administration. Detractors said the call was politically timed and contained a $2 trillion error.

As markets awake in the U.S Monday August 15, it’s unclear what S&P accomplished in the week that was. Here’s a scorecard.

S&P called attention to a dangerous debt overhang that has been the focus of attention for a year. The real pain from the debt buildup will not hit until later this decade when if nothing changes, 40% of U.S. tax revenues would go to pay interest on the mounting pile of bonds. By acting now, S&P officials said they were calling attention to the dangers of holding the bonds over time.

Critics of the Obama administration said this downgrade proved the President was endangering America’s future.

Certainly Americans everywhere had a new reason to hate Washington after an ugly month. They’d watched politicians pointing fingers at each other like short-pants-kids in a schoolyard, fomenting a crisis over raising America’s need to sell more debt when most expected they’d have to raise the borrowing limit. The blame-game was over how much to cut spending versus how much to raise taxes. The S&P verdict implied that after all the noise; Washington had accomplished little to fix its financial gap.

The downgrade injected raw fear into the markets in August, a time when trading rooms have less experienced staffers in charge while the veterans are on vacation. The August vacation season also means less trading volume which means jumpy greenhorns in charge can create volatile markets with smaller deals.

The downgrade also played into waves of concern over Italian and southern European debt.

The fear drove swept across Wall Street but the outcome was perverse. Stock selling collapsed the S&P 500 index down 6.7% in a day, a reminder of the sickening start of the 2008 crash, when stocks eventually fell by 45%. Bondholders seeking safety did the opposite. They raced to buy the same Treasury securities that S&P had downgraded, sending rates on the 10 year bond to a historically cheap 2.03%, saving taxpayers over $600 billion in interest costs. If the U.S. really wanted to borrow cheap, it should scare the world once a week, was one conclusion.

Writing under the title “The Folly of S&P”, Adam Hersch, an economist for the Center for American Progress in Washington observed: “S&P’s decision to proceed with the downgrade after admitting to errors left many observers wondering what good are S&P ratings anyway”.

Hersch pointed out that in 20 cases of S&P country downgrades that warned of trouble since 1975, including Japan and Canada, borrowing conditions improved. But when countries really blew up, like Thailand during the Asian Crisis of 1997 and Mexico in the 1994 Mexican peso collapse, S&P was 3 months late in issuing an after-the-fact downgrade.

I have written about the ratings agencies before and as an editor of BusinessWeek, had a personal relationship with raters at S&P because we were both owned by McGraw-Hill Companies. Like journalists, S&P raters have been protected by the U.S. First Amendment, which says they are only giving an opinion based on their best judgment. That means S&P can say pretty much what it wants to say as long as it proves it was making a judgment without malicious intent.

Unlike journalists however, raters drive profits. In testimony to Washington investigators, rating officials described how they were driven to compete fiercely for fees and market share on rating sub-prime debt. The Chairman of McGraw-Hill Companies Harold (Terry) McGraw III, plays extremely close attention to every action at S&P, which remains his company’s profit center. McGraw, a close supporter of former President George W. Bush, has been silent during this downgrade.

But it has been taken personally by President Obama and his staff as a political decision that could have been issued later – or not at all – since it is based on a calamity in 2020, if nothing changes. Obama’s officials have made much of a $2 trillion baseline estimating mistake that S&P admitted but said did not affect its outcome.

All of this means there is a political as well as economic flashpoint underlying this “Ratings Week That Was.” Conservatives are pleased to see the President get slapped down. Obama’s supporters are crying “politically motivated hit job.”

Obama’s friends in Congress are calling for an investigation. China is talking up its own ratings agency which downgraded US Treasuries a few days before S&P did. But with free speech fully suppressed in China, it is hard to trust the independence of its ratings. European leaders are reviving talk of creating their own credit rating agency.

Back in the U.S., there’s a question of “what was that all about”? Terry McGraw remains silent. Warren Buffett says the action was wrong. Bond guru Bill Gross of PIMCO says it was overdue. On three continents, four if you count Australia, it appears that things have suddenly become unstuck.

Kevin Rudd is no longer the Australian prime minister. But if he’s still smarting from the ratings debacle of 2008 and still keeping tabs on the rating agencies, perhaps his payback time is not far away.

Bob Dowling is an independent international journalist and adviser to Gateway House.

This article was exclusively written for Gateway House: Indian Council on Global Relations. You can read more exclusive content here.

For interview requests with the author, or for permission to republish, please contact outreach@gatewayhouse.in.