POOR-MOUTHING UNCLE SAM
Nov 27, 1995, Vol. 1, No. 11 • By JAMES HIGGINS
AN UNEXPECTED PLAYER made a last-minute entry into the federal budget debate on November 10: The rating agency Standard & Poor announced that investors" faith in the U.S. government had already "diminished" because of the budget deadlock and that, if the United States were any other country, the agency would already have put it on "Credit Watch" for a downgrade from triple-A.
While this made superficial sense, a closer analysis reveals that Standard & Poor's either had lost touch with the meaning of creditworthiness or had entered a partisan debate on the Democratic side, or both. There are strong theoretical and historical reasons for discounting Standard & Poor's comments.
First, it has never been clear what a credit rating is supposed to mean when applied to the sovereign debt a country issues in its own currency. A Standard & Poor's credit rating is supposed to evaluate a borrower's ability to repay principal and interest. One of the distinguishing characteristics of a sovereign borrower is its ability to print money. While there may be some doubt about the ability of, say, Mexico to repay its dollar-denominated obligations, there should be no doubt about the ability of Mexico to repay its peso-denominated obligations. The same reasoning applies to dollar- denominated U.S. debt.
One may object that printing money to repay debts -- literally monetizing the deficit -- is inflationary and should therefore result in a lowering of the sovereign borrower's credit rating. This is a fair objection; but raising it must lead one to ask why Standard & Poor's never threatened to down-grade U.S. government obligations in the 1970s, when the debt was being monetized aggressively and inflation was spinning out of control.
Second, if Standard & Poor's does not have a partisan agenda, then it is hopelessly confused about the difference between lack of solvency and lack of liquidity. Solvency involves the wherewithal of the issuing entity to pay principal and interest on its obligations: Does the issuer have the resources -- the assets or the cash flows -- to make the needed payments? There is not the slightest doubt that the federal government, the ultimate taxing authority in the land, has both the resources and the willingness to assure payment of all its obligations. Nor has there been the slightest consideration of repudiation of or compromise on any portion of the federal debt. So the budget confrontation has had no impact whatsoever on the solvency of the federal government. Liquidity involves the availability of funds in the short run: Is there enough cash in the till to pay the bills today, or will it be necessary to wait until tomorrow, next week, or next month?
Standard & Poor's intervention at this time necessarily implies a bizarre focus on liquidity and an utter unconcern with solvency. All the emphasis is on the ability of the government to pay bills this week versus next week; no consideration is given to whether perpetual deficits will drive the government to ultimate financial ruin. If these peculiar priorities are not actually those held by Standard & Poor's, why did the agency never raise the slightest objection as presidents proposed one budget after another projecting losses (deficits) forever? This sudden obsession with liquidity and simultaneous indifference to solvency smacks of partisanship.
Third, there has been no indication that Standard & Poor's would actually be willing to follow through on the implications of its ominous warning. If the obligations of the U.S. government are downgraded, what are the consequences for companies that hold large quantities of U.S. obligations -- bonds, notes, bills, and cash? Has Standard & Poor's come to terms with the number of companies that would be candidates for downgrades if the U.S. obligations on their balance sheets were deemed to be of diminished credit quality? It would be rank hypocrisy to ignore this implication of the downgrading of U.S. obligations and cash.
Fourth, moving beyond theory, credit rating agencies do not have a stellar reputation for grasping the "big picture." Rating agencies do a reasonably effective job of evaluating the relative financial strength of companies within the same industry. If you want to know which companies in an industry are more or less likely to have financial problems in a prolonged downturn, credit ratings are not a bad guide. But if you want to understand whether the emperor is wearing any clothes at all, don't call Standard & Poor's for help.
A recent and notable example: Japanese banks. By 1990 virtually every bond trader, salesman, and portfolio manager in the United States understood that the Japanese banking system was a house of cards; that purportedly ample capital ratios were built on ludicrously inflated asset values. All the market participants had gotten the joke, but the rating agencies hadn't. They were focused on nominal compliance with Bank for International Settlements capital ratios and other statistics that turned out to be irrelevant; so they were still giving triple-A ratings to a number of Japanese banks. The rating agencies apparently had not a care or a clue about the business practices that were leading these banks to hold at least $ 370 billion of bad loans.
I particularly remember trying at that time, as a mortgage trader, to sell one bond that was rated triple-A by virtue of a supporting letter of credit issued by the U.S. branch of a prominent Japanese bank. My colleagues and I knew from the outset that the deal would be a tough sell because of the undesirable letter of credit. One sales call was to a prominent west coast money manager. "In what trailer," came the money manager's withering reply, " is that branch located?" Other money managers were less caustic but equally -- and correctly -- dismissive of the triple-A rating. So it's not particularly surprising that a rating agency that didn't understand what was financially wrong with Japanese banks wouldn't understand what's financially right about a serious effort to balance the federal budget.
Finally, one must note the similarity between Standard & Poor's pronouncement and Treasury Secretary Rubin's rhetoric. Even the New York Times observed that Standard & Poor's warning "almost exactly parallels warnings issued recently by Mr. Rubin." Secretary Rubin wasted no time showing up on the network talk shows, waving Standard & Poor's "objective" caution.
Coincidence? Perhaps, but perhaps not. Mr. Rubin's former firm, Goldman Sachs, must deal with rating agencies every day. Perhaps Secretary Rubin's direct and indirect contacts at Standard & Poor's haven't all disappeared. The secretary should be called before Congress and asked under oath whether he took any steps, direct or indirect, to encourage Standard & Poor's to issue this warning. Telephone records should be subpoenaed if necessary. If it is established that Secretary Rubin did encourage Standard & Poor's statement, he should pay the same penalty that any other chief financial officer would pay if found encouraging a negative rating-agency report on his employer: He should be fired.
James Higgins has worked for eight years for primary dealers in U.S. government securities, most of that time trading securities rated by the major rating agencies.