The Times today has a long piece about companies that lost their AAA ratings, with the number of nonfinancial AAAs going from 60-ish in the 1980s to four (JNJ, ADP, XOM, MSFT) today. Why did they lose the AAA rating? Well, "it became seen in board rooms as more of a straitjacket than a path to riches. Just as many consumers relied on their credit cards to finance a higher standard of living, companies took on more debt to reap bigger returns." Or, in UPS's case, "the ratings agencies started knocking down the company’s credit rating to AA because of the new pension arrangement" that it struck with its unions in 2007.
So ... know anyone else who is borrowing to try to juice economic growth and/or dealing with ballooning retirement-and-medical obligations? Oh, right, those guys. America. Which Moody's and Fitch reaffirmed at AAA (negative outlook) yesterday and which S&P is going to moan about for a while longer. The Times again:
But the truth is, even as the government maintained its AAA grade, the markets suggested long ago that the United States was no longer deserving of such a high rating.
The credit-default swap market provided one clue. ... Even today, the price of insurance on a government default has been higher than that for Colgate Palmolive, the global toothpaste giant, which has a rating two notches below AAA.
Which is weird, right? Because sovereign ratings mostly overpredict default - that is, default rates on sovereigns at a given rating are below those on corporates. Here's somewhat old S&P data:
So why would the market think that a default on AAA U.S. debt is more likely than a default on AA Colgate Palmolive? Especially since, unlike European sovereigns, the U.S. can print money? As Dean Baker asks:
The debt is issued in dollars. That means that the U.S. government is committed to paying it off in dollars. The U.S. government also prints dollars. So does a downgrade mean that Moody's thinks that it is possible that at some point we will forget how to print dollars?
Well, let's see what Moody's thinks. Here's what they had to say in last night's release:
Moody's placed the rating on review for possible downgrade on July 13 due to the small but rising probability of a default on the government's debt obligations because of a failure to increase the debt limit. The initial increase of the debt limit by $900 billion and the commitment to raise it by a further $1.2-1.5 trillion by yearend have virtually eliminated the risk of such a default, prompting the confirmation of the rating at Aaa.
In confirming the Aaa rating, Moody's also recognized that today's agreement is a first step toward achieving the long-term fiscal consolidation needed to maintain the US government debt metrics within Aaa parameters over the long run. The legislation calls for $917 billion in specific spending cuts over the next decade and established a congressional committee charged with making recommendations for achieving a further $1.5 trillion in deficit reduction over the same time period. In the absence of the committee reaching an agreement, automatic spending cuts of $1.2 trillion would become effective.
In assigning a negative outlook to the rating, Moody's indicated, however, that there would be a risk of downgrade if (1) there is a weakening in fiscal discipline in the coming year; (2) further fiscal consolidation measures are not adopted in 2013; (3) the economic outlook deteriorates significantly; or (4) there is an appreciable rise in the US government's funding costs over and above what is currently expected.
The bulk of this is what the agencies are talking about these days - anemic GDP growth, "fiscal discipline," etc. But the first paragraph tells you what actually drove the agencies to rethink their ratings: Moody's was thinking about downgrading the U.S. because Congress was seriously considering whether to default for the hell of it, but they ended up going with no, so, sweet, no downgrade.
And that's the important part. After all, our deficits were just as bad three weeks ago - worse, actually, if you believe that the debt-ceiling deal cut spending - but we weren't on negative outlook until the debt ceiling debate noise started getting louder. No, what brought the U.S. to negative outlook, and the ratings agencies to so much national attention, was not debt levels or GDP growth rate. It was the prospect that goons in Washington were going to forget how to print money.
As S&P's sovereign ratings primer linked above explains:
Willingness to pay is a qualitative issue that distinguishes sovereigns from most other types of issuers. Partly because creditors have only limited legal redress, a government can (and sometimes does) default selectively on its obligations, even when it possesses the financial capacity for timely debt service. In practice, of course, political risk and economic risk are related. A government that is unwilling to repay debt is usually pursuing economic policies that weaken its ability to do so.
The agencies are now making lots of serious public statements about economic policies and fundamentals, even though those are arguably pretty second-order in terms of whether the U.S. might default on its debt. (Incidentally FT Alphaville points out that Marc Joffe, formerly of Moody's, has proposed a demographic approach to sovereign ratings that arguably does a better job of taking into account ability to pay off debt with future taxes.) They've minimized talk about the real risk, which is that our Congress just won't feel like paying our debt any more and so will default.
That's probably the best way to interpret market reactions. Rates on the $10 trillion of publicly held Treasuries couldn't be tighter, suggesting that there's no real market worry about the U.S.'s ability to pay off its debts. But CDS notionals keep increasing (albeit in a still small and illiquid market) and CDS levels are wide of AA corporates because the U.S. is actually more likely to default than Colgate Palmolive is. Because it would not occur to anyone at Colgate Palmolive to just stop paying its debts. But we're going to have to keep rasing the debt ceiling, and every time we do, half of Congress is going to say that they prefer to default.
If you look at the U.S.'s safe-haven and reserve-currency status, our borrowing rates, and our ability to print money, then the AAA rating still looks pretty solid. If you look at our political system, even AA+ seems way too generous. The interesting question is why the agencies, after putting the U.S. on negative watch entirely because of the political antics that are now built into our system, are now focusing entirely on economic and fiscal fundamentals.
Two possible answers come to mind:
1. After the financial crisis, the ratings agencies don't exactly have a lot of credibility in criticizing anyone else's decision-making process, and pinning a credit downgrade on Congress's childishness is not going to win them friends in Washington or elsewhere.
2. They really believe in their concerns about debt sustainability - but they hadn't noticed the U.S.'s debt problem until the debt ceiling debate woke them up to it. Which ... actually seems to be consistent with their past performance.