What to do about the ratings agencies

by John Quiggin on August 7, 2011

S&P’s decision to downgrade US Treasury bonds from AAA to AA+ has elicited various reactions, some of which I’ll doubtless repeat here. Obviously, S&P has no particular expertise (apparently it couldn’t even get the arithmetic right) and based on its historical and continuing performance, its opinions ought to carry no particular weight with anybody (they say so themselves, when under pressure over obvious cases of misrating, asserting that they are merely offering an opinion).

On the other hand, it’s also pretty obvious (and even more so after the Repubs successful use of the debt ceiling to force Obama to abandon any call for tax increases along with the cuts they both wanted) that the US has some fairly intractable problems in dealing with its (technically quite manageable, but still substantial) public debt. Finally, as I said last time I discussed this, a decision of this kind (including a decision to maintain AAA ratings) is inherently political

There are two reasons why S&P’s choice of rating matters more than, say, my own opinions on the matter

  • First, a lot of investors still pay attention to ratings agencies, for whatever reason
  • Much more importantly, agency ratings are embedded in global regulations concerning prudent management of investment. If a second major agency were to join S&P in downgrading, large numbers of institutions would be debarred, under existing rules, from investing in Treasury bonds

That’s clearly unsustainable, so what will happen?

All sorts of fudges are possible, but the only clean response is to remove reference to private agency ratings from regulations prescribing prudent management of investment. Under current rules, provided managers invest in AAA-rated assets they are normally regarded as having discharged their duty of care. On the other hand, the agencies insist that their ratings are mere opinions, and that they have no duty of care whatsoever in offering them. Dodd-Frank was supposed to fix this, but as I just discovered (H/T Anders Widebrant), the SEC has abandoned any attempt to implement this part of the law.

But what is the alternative. I (and others) have previously floated the idea of a public ratings agency, but I now think this is a roundabout and inappropriate solution to the problem of defining a safe harbor for institutional investors. What is needed, simply, is a list of approved investments drawn up by the relevant regulators. Investors who choose assets outside this list would do so on the basis of their own judgements and would have to defend that judgement in the event of default.

There are some crucial differences between this and the existing system. First, regulators take responsibility for their own decisions, rather than outsourcing them (though some may choose to use a common list). Second, and most importantly, this approach reverses the onus of proof regarding financial innovation. If someone comes up with a new financial instrument, and a theory as to why it is (almost) risk-free, they have to persuade regulators (who will carry the can if something goes wrong) to approve it. Under these circumstances, the kinds of institutions that are required to make prudent investments will be effectively excluded from investing in innovative instruments. Given the history of financial innovation, that’s a good thing.

There are still problems here. Lots of governments have AAA-rated debt and lots more would like their debt regarded the same way, even if (or especially if) they are not pursuing particularly prudent fiscal policies. Obviously they would like, and will pressure, regulators to take a favorable view, and will be particularly miffed if their debt is dropped from an approved list. There are several cases here. One is the case where the regulator is responsible to the government concerned. In that case, I think nothing can be done or should be done. The government will declare that someone who invests in its own securities has done nothing wrong – institutions regulated by that government will have to make up their own minds whether or not to do so. The second case is that of the debt of foreign governments – here a downgrading might involve some embarrassment, but as long as it is done by independent regulators. The third, and trickiest case is that of regulation in a federal or confederal system (US states or EU member countries). I haven’t thought through this one yet, so I’ll leave it for comments.

What would happen to the ratings agencies if they were cut out of the regulatory loop? I’d guess that they would continue the business of rating ordinary corporate debt, much as before, but they would lose a lot of business associated with rating innovative financial instruments (given their record of failure in this area) and government debt (given that they would be competing both with regulators and with CDS markets).

{ 251 comments }

1

Sprizouse 08.07.11 at 4:53 am

How about the purchasers of debt securities pay a fee to have their bond purchases rated (instead of the other way around). Then, if the securities default and the security was short-term rated, oh I dunno, say BB- then the purchaser gets that fee back. If the long-term rating was BBB+ and the security defaults then the purchaser gets their money back plus interest plus a penalty fee?

I just thought about this in the last five minutes and I’m a bottle and a half deep into some good Chianti, so this obviously needs to be reworked and thought about in more depth by someone who isn’t drinking.

2

Ed 08.07.11 at 4:58 am

Some points:

You are confusing MBS ratings with sovereign ratings, a common mistake in most of the blogosphere. In fact, rating agencies have a good track record on sovereign ratings, as evidenced in the default studies that are published annually. The IMF recently wrote about this.

While plenty of people follow what happens in the US and therefore can form their own opinions, rating agencies are among a very small group the regularly meets with the governments of 100+ countries and rank orders them. That’s where what rating agencies do differs from people that simply read the news.

That also explains why so many investors listen to rating agencies (and hire their analysts for that matter). Because few other market participants have such a structured approach to look at the whole world. Of course, this does not mean they have to agree with rating agencies, many times they do not. But unlike what you read in the popular press investors value what a rating agency analyst has to say.

Rating agencies have repeatedly said they support being taken out of legislation. The reason this has not happened is clear, if you talk to regulators across the world. There is no easy alternative. A public rating agency? Can you imagine the ECB or some EU-sponsored rating agency forced to downgarde Greece? Talk about conflict of interests.

3

StevenAttewell 08.07.11 at 5:09 am

I don’t agree that public rating agencies are “this is a roundabout and inappropriate solution to the problem of defining a safe harbor for institutional investors. What is needed, simply, is a list of approved investments drawn up by the relevant regulators.”

I don’t see the difference – a regulator is defining what are and aren’t approved investments either way. Moreover, given the proposed mechanism of randomly chosen competing agencies, there’s the increased difficulty of regulatory capture compared to the sorry state of the SEC.

4

StevenAttewell 08.07.11 at 5:10 am

“Can you imagine the ECB or some EU-sponsored rating agency forced to downgarde Greece?”

Yes. Can you imagine Moody’s or S&P downgrading the people paying them fantastic sums explicitly for AAA ratings on pure garbage CDOs and the like?

5

Ed 08.07.11 at 5:16 am

StevenAttewell @3:

If you are going to argue that the issuer pays model always leads to much too high ratings you need to explain why this was never a problem in all the previous decades this same model was in place, or in any of the other asset classes (including sovereign ratings) that rating agencies cover.

6

Ed 08.07.11 at 5:18 am

For anyone interested in really understanding sovereign ratings this may be a good first start:

http://www.imf.org/external/pubs/ft/gfsr/2010/02/pdf/chap3.pdf

7

John Quiggin 08.07.11 at 5:22 am

@1 I’m well aware that these are different and use different criteria – the problem is that the ratings agencies use the same scales, with the result that some trash dreamed up by an investment bank on the basis of unrepayable mortgages gets a higher ranking than say, the debt of the Queensland state government, a member of a federation in which no state has ever defaulted (NSW tried a partial default in the Depression, but the Feds paid the interest and the state government was forced out of office).

I’ve seen the statements by the agencies that they don’t want to be part of the regulatory process, but I think they are bluffing. If the rules were changed to exclude ratings (unless they were prepared to the standard of a professional opinion) they would lose an awful lot of business.

8

dictateursanguinaire 08.07.11 at 5:25 am

@ Ed

Not trolling you but I’m underinformed on CRAs and the various distinctions you seem to see and your argument seems to be a version of a popular one I’ve heard along the same lines. Since you seem to accept that they performed badly (or were fraudulent) in the MBS deals, why is (or do you think) the situation different for states? Which factors change? Do you have any concerns, even if key factors do change, that groups like S&P, which seemingly have questionable ethics, may have systemic problems vs. case-by-case ones? Again, honest, good-faith questions, just interested in your take.

9

Ed 08.07.11 at 5:27 am

Actually the rating agencies do not always use the same scale, as some have begun to use suffixes to identify the asset class. But this is an imperfect solution, as most investors want one single scale for all.

Municipal debt has created, for a variety of historical reasons, its own market approach.

It’s not clear they would lose a lot of business. Contrary to your claims investors value rating agency output. But in any case we won’t know until the legal changes are made.

10

StevenAttewell 08.07.11 at 5:27 am

Ed – it has been a potential weakness in previous decades. Witness the internet bubble of the 1990s, or the Asian financial crisis, or Enron, or or or….

11

Ed 08.07.11 at 5:32 am

@7 If you look at rating agency history you can divide their output into two big piles. One are the MBS deals of the last few years. The other is all the rest (including prior MBS deals). Concerns about the quality of the ratings only apply to the first group (there are some other concerns about the comparability of the asset classes, but that’s a different issue). The rest has no such concerns.

In fact, prior to this crisis anyone who followed what rating agencies did would know that, if anything, the argument was that they were too conservative. When I first started working on ABS deals some 15 years ago the big question was why weren’t the structured finance ratings much higher as there were almost no examples of SF defaults.

12

Ed 08.07.11 at 5:35 am

@9 I’m afraid that makes no sense. The rating agencies had nothing to do with the internet bubble (that was equity and the rating agencies only look at fixed income) and on the Asian crisis the argument was that the rating agencies were too harsh, the opposite of what you claim.

The idea that the issuer pays model is the reason for the MBS ratings is the sort of quick blogosphere reasoning that appears to make sense until you start looking at the details.

13

Ed 08.07.11 at 5:46 am

By the way, note how what Steven says in @3 and John in @6 contradict each other. Steven claims that the issuer pays model leads to inflated ratings. But the same issuer pays model, when applied to municipal debt, appears to lead to lower, not higher ratings (at least when compared to other asset classes).

14

StevenAttewell 08.07.11 at 6:04 am

1. Regarding the internet bubble, there’s a neat parallel with the issuer pays model of the stock analysts, and I note you said nothing about the Enron scandal. We could throw the junk bond crisis of the 1980s in as well. This isn’t a very good track record, given that the shift to issuer pays only happened thirty-odd years ago.
2. As for Asia: “During the 1997-98 Asian currency crisis, ratings agencies were castigated for failing to spot unsustainable capital inflows that led to currency collapses across Eastern Asia and deep recessions.” Is this wrong?
3. As for municipal debt, are you really suggesting that municipalities have the same capacity to play the “work the ref” game that the CDO issuers did?

15

Ed 08.07.11 at 6:14 am

Steven:

1. I can’t make heads or tails of what you are saying. You keep jumping from one topic to another, We are talking about ratings, why are you bringing up internet stocks? Let’s try to focus on one thing at a time. And what junk bond crisis are you talking about? You do know that junk bond means they are rated very low, right? So what is your argument here?

2. I don’t know if its wrong but it surely is irrelevant. Rating agencies don’t seek to measure currency changes or recessions, only defaults. And as I explained above the record is pretty good.

3. Again, you are not clear. Your argument was that the issuer pays model leads to higher ratings and I just gave you a counterexample.

Apologies in advance, but I can’t help but feel that you’ve been reading blogs about this but have no real understanding of the topics. You seem to jump from one thing to another completely unrelated.

Finally, on Enron. This is another common misunderstanding. Enron was a case of fraud, and rating agencies are not auditors.

16

John Quiggin 08.07.11 at 6:14 am

@11 IIRC correctly, there were a number of big dotcom corporate bankruptcies missed by the ratings agencies until it was too late – Enron, Worldcom, Global Crossing etc

@12 There’s no contradiction between saying that they apply different standards to goverment and private bonds and saying that private issuer ratings are too generous.

17

John Quiggin 08.07.11 at 6:16 am

Ed, is it correct that the issuer-pays model applies to sovereign debt? I had the impression not, but can’t find a clear statement one way or the other.

18

John Quiggin 08.07.11 at 6:25 am

Responding belatedly to your defence of the agencies re Enron, this company was repeatedly honored by Forbes magazine for its innovative financial strategies. A competent assessor of bondholder interests would have seen this as a gigantic flashing red light.

19

Ed 08.07.11 at 6:26 am

John @ 15.

1. First of all, do you have any data on what the ratings of those companies were at the time? I don’t recall. In any case, leaving aside the issue of fraud which I mention above, remember that ratings are probabilities, and can only be judged as such. An A rating does not mean the company can’t default, it only means that it is very unlikely. So you can’t simply pick some individual examples, you need to look at the whole group. That’s what the rating agency default studies do, they look at how cohorts of ratings perform over time. I realize that the “But what about Enron” approach is psychologically powerful but it is also analytically useless.

2. it seems we are changing the argument. The first version of the argument was that issuer-pays leads to inflated ratings, now we are saying that only happens to private issuers? What do you call it when you keep changing the theory to fit the data that is refuting it? In any case even that doesn’t fly, since we have ample examples of private issuer-pays ratings with no problems, namely the corporate ratings, probably the ones with the most empirical information. Again, they are updated every year and show nonne of the problems of the MBS market. On top of that we also have the history of MBS deals prior to the crisis. also issuer paid and, if anything, with much too low ratings.

I’m afraid your theory is not supported by the data.

20

Ed 08.07.11 at 6:28 am

John @17, yes, sovereigns also pay, but not all of them. Strangely enough it seems that the ones that pay tend to have the lower ratings (there’s a historical reason for that).

21

john c. halasz 08.07.11 at 6:52 am

22

John Quiggin 08.07.11 at 7:00 am

It’s you who is shifting the ground to suit your case.

I said, and repeat, that Australian sovereigns are rated lower than high-risk MBS issuers. You shifted ground to US munis. I didn’t raise the question of issuers pays, but I’m pretty sure that Australian governmetns don’t pay for ratings, so unless you have evidence to the contrary, my claims are consistent with those of Steven Attewell.

As regards Enron S&P affirmed a BBB+ rating in late 2001. Global Crossing was BBB.

Here’s a post from Egan Jones (rivals of course, but the facts are right) which refutes your original claim that the failures of financial markets in the dotcom era were confined to equities and the investment banks that rated them

http://www.sec.gov/news/extra/credrate/eganjones2.htm

23

musical mountaineer 08.07.11 at 7:00 am

This is the second post I’ve seen on CT, pooh-poohing something S&P said about America’s credit rating. The other post, I seem to recall, was by Daniel Davies, where he said they were tugging on Superman’s cape.

I suppose, then, there’s nothing to worry about. S&P has had crappy performance at rating derivatives and other baroque instruments, so there’s no reason to credit any dirt they may dish on the good old US of A.

But then, it seems to me, rating derivatives and such must be really, really difficult. You’d have to dig deep into mazes of complexity, slog through mires of corruption, and probably break the law to find out what’s really backing up these securities. That’s if you’re not corrupt yourself, which you have every reason to be, whether in the private or public sector. I doubt whether meaningful ratings can be established at feasible cost, under any rating regime.

On the other hand, it’s not so difficult to pronounce on the credit of the Federal Government. You can skip questions such as “exactly what does my boss want me to say is the pro-rated-by-debt component-adjusted average credit rating of all debtors owing loans bundled in this 27th-order derivative?” and just work with numbers pretty much everyone agrees on. Like GDP, tax revenue, debt, deficit, interest, etc. Further, you can study the political scene to get a clue whether repayment is likely.

Sure, whatever, S&P has no real credibility, they’ve been corruptly jacking up the numbers for some of the stuff they rate. Thing is, I’m pretty sure that includes Uncle Sam. If anything, it’s alarming that S&P took this long to downgrade. Under the circumstances, it’s a wonder there’s any credit anywhere on any terms. Obviously an epic default-by-inflation is coming, and creditors will all be skinned alive.

Or maybe I’m wrong. Maybe, buying US Government debt is still a good call. But how?

24

Ed 08.07.11 at 7:07 am

John,

Once again, ratings are probabilities. I am certain I don’t need to remind you that you don’t disprove probabilities by citing individual examples. Global Crossing, Enron, etc.. are all irrelevant. What matters is the overall probability of the different rating cohorts. That’s how this is measured.

Australian local governments pay for their ratings. But if you don’t claim, as Steven Atwell, that the issuer pays model is the problem, then there’s no need to debate this particular point any more.

25

Walt 08.07.11 at 7:13 am

Musical mountaineer, you’re completely wrong about how derivatives are evaluated. The issuers of derivatives pay for the ratings, and provide the information. No illegality required.

26

Ed 08.07.11 at 7:18 am

To simplify, here are my points:

1. Ratings have generally a good record, as evidenced by annual defaults studies. This includes sovereign ratings. The one huge exception are the MBS ratings of the mid 2000s.

2. The idea that the issuer pays model leads to inflated ratings is contradicted by the evidence. This includes both the historical evidence since the 1970s as well as the evidence from looking across asset classes.

3. There’s an important debate about the role of rating agencies in regulations. We’ll have to wait and what regulators do, but rating agencies have made clear they agree with bing written out of the regulations.

27

Jamie 08.07.11 at 7:20 am

I’m sure this is naive, but I’ve suggested it before, and haven’t heard good reasons (other than, you know, it won’t happen) why a money-where-one’s-mouth-is rule wouldn’t work. S&P can rate, and sovereigns can require ratings, and S&P is required to issue, call them collateralized ratings obligations, that pay if the pool of rated investments defaults at greater than a certain rate.

That should make the anarchy-capitalists happy, at least.

28

soru 08.07.11 at 7:49 am

pay if the pool of rated investments defaults at greater than a certain rate.

Surely, unless the credit agencies had literally half the capital in the world, then the chances of them paying out on that, under the circumstances in which they would need to, would be rateable at about EE–?

29

critical tinkerer 08.07.11 at 8:37 am

Ed
1. Ratings have generally a good record, as evidenced by annual defaults studies. This includes sovereign ratings. The one huge exception are the MBS ratings of the mid 2000s.

Good record???? If they do not have a perfect record what is the point in having their opinion? Anyone with a MBA background and a day of research can grade sovereign debt. Sovereign finance should be public record and easy to research. If it is not , then the rating should not be given. Same with “too complex” MBS. If it is so complex so be difficult to analyse then why did they stand behind their rating?

Rating agencies are supposed to be PR resistant and analyse only the finance numbers, not to fall for sales pitches as the non-pros do.
Considering that munies are very safe, they still have to be incentivised by tax-free status in order to attract the investors because their low rating. While corporate bonds, MBS, cds (very new product) enjoys better ratings then public debt, it is obvious that rating agencies are susceptible to the hype, just as any person.

I am not for changing it into a completely new system, with new criteria and then to get trough growing pains again, when we know where the weaknesses of this one are. I am for “sprizouse” suggestion of penalty for failing to rate it correctly and timely.

30

Lemuel Pitkin 08.07.11 at 9:09 am

If a second major agency were to join S&P in downgrading, large numbers of institutions would be debarred, under existing rules, from investing in Treasury bonds

Is this true, tho? Aren’t the legal cutlets typically much lower, in the BB+ range? What is an example of an institution legally required to hold only AAA bonds?

31

Lemuel Pitkin 08.07.11 at 9:10 am

Er, cutoffs.

32

Agog 08.07.11 at 9:40 am

Ed – you defend CRAs as having “generally a good record” on rating sovereign debt but gloss over the specific instance – this instance – of S&P making rather a large error in their calculations.

(http://www.treasury.gov/connect/blog/Pages/Just-the-Facts-SPs-2-Trillion-Mistake.aspx – in case anyone doesn’t read the news)

Of course one mistake is only one mistake, but that was a biggy wasn’t it? And it does raise some doubts about motives as well as competence.

33

Tim Worstall 08.07.11 at 9:42 am

Who pays for sovereign ratings is rather important though, isn’t it?

I’m pretty sure the UK or the US don’t: in which case the ratings agencies, unless they’re just doing this as a public service, must be being paid by the buyers. In which case (absent the regs about having to hold AAA etc) they’re simply private companies providing a private opinion.

In which case, what’s the problem? They’re of no more moment than a stockbroker issuing a buy or sell rating.

34

Andrew F. 08.07.11 at 11:03 am

A few critical (respectfully offered) comments:

1. You write: All sorts of fudges are possible, but the only clean response is to remove reference to private agency ratings from regulations prescribing prudent management of investment. Under current rules, provided managers invest in AAA-rated assets they are normally regarded as having discharged their duty of care.

That second sentence isn’t true. A manager’s fiduciary duty goes beyond merely investing in securities rated X. Not only does the manager have to investigate an investment more thoroughly than simply checking a rating, she must also fully disclose her methods and reasoning to the client.

Typically ratings may function as a screen for investments. A top rating may be a necessary – but not sufficient – condition for investment.

2. Your proposal could diminish protections offered to investors.

If a regulatory agency publishes a specific list of approved investments for certain funds, then it sounds as though investors will have no one to ask for redress except the government if that list turns out to have some poisoned apples. That’s not an appealing notion. I’d much rather a large financial institution be liable than attempt to sue the government for shoddy investment advice.

3. The real concern is to prevent a ratings downgrade from having influence on the market beyond the “appropriate” informational value provided by the downgrade.

To do this, one need not take the drastic step of specifying ALL suitable investments for certain funds or purposes.

Instead, one may specify certain types of securities – US Treasuries for example – as suitable, and for classes of securities where we are less concerned about the systemic effects of a downgrade, allow ratings to continue to function as a filter.

This is what is already done with US Government backed debt in many areas, and is how the ECB insulated Irish debt from some effects of downgrades.

35

Sherman Dorn 08.07.11 at 11:30 am

Thank you for the discussion! Anyone else think that the public dance by S&P over the US sovereign rating might be a form of Schmertztverkauf, essentially trying to regain some legitimacy by pointing to others’ ills?

36

Henri Vieuxtemps 08.07.11 at 11:47 am

Finally, as I said last time I discussed this, a decision of this kind (including a decision to maintain AAA ratings) is inherently political [….] What is needed, simply, is a list of approved investments drawn up by the relevant regulators.

Unless I misunderstood something, it seems like what you’re suggesting would make it even more political. You did address this concern for the case of the regulators rating their own government, but I see no reason to assume that rating foreign governments is any different. US regulators assessing Iran or Venezuela? Who would trust it? It could just become another tool for conducting foreign policy; bullying/bribing foreign governments.

37

Ginger Yellow 08.07.11 at 11:51 am

As regards Enron S&P affirmed a BBB+ rating in late 2001. Global Crossing was BBB.

What’s this supposed to prove? BBB is not a high rating category. It’s technically investment grade, but it’s right at the bottom. BBB is the sort of rating the very bottom, or second bottom tranche of a “high risk MBS” gets..

38

bob mcmanus 08.07.11 at 11:56 am

Ian Welsh

If Obama did not want this to happen, it would not happen. Could you imagine what LBJ, Nixon or Truman (or, hell, Bush Jr.) would have done if a rating’s agency tried this? The President has the necessary tools to utterly destroy S&P and every senior analyst working for them. You could use terrorism statutes or RICO, just as two examples. Send the FBI into their offices, seize all the assets of both the company and everyone working for it, and then got through their records. I guarantee, as absolutely as the sun will rise tomorrow morning, that there is enough evidence of fraud in those records to put them away for life. In the meantime, RICO laws are used to seize all the assets of everyone involved*, meaning they will be using public defenders (don’t like a bad law? Use it against real people.)

*This also means the banks. Shut them all down and take their stuff. These reformist responses to these 75-year or once-in-a-century events like the GFC and the ratings downgrade are starting to look a little desperate and pathetic, the triumph of hopelessness over inexperience. We are in Revolution. The structures you are depending on are vaporizing under your feet.

But Obama and the financial class are simply using Shock Capitalism as if N Klein’s book were their blueprint.

39

Ginger Yellow 08.07.11 at 11:58 am

Also, I’d hesitate to make too much hay out of the $2tn error, other than as support for the (true) argument that rating agencies make mistakes and so shouldn’t be relied on over doing the work yourself. The error relates to a baseline projection of nominal GDP growth, according to the Treasury, of just under 5%. Anyone who thinks we’re going to have just under 5% nominal growth for the next ten years will probably think the US is AAA. But I think both are wrong.

40

Walt 08.07.11 at 12:08 pm

The evidence you’ve provided is laughably weak, Ed. Your standard is basically “do the ratings agencies do better than random chance”. Yes, I think everyone will concede that the ratings agencies do better than random chance. This is like judging mutual funds on absolute return. The big ratings agencies have every incentive to set the bar low for themselves, since they have entrenched market positions.

41

jfxgillis 08.07.11 at 1:13 pm

John:

My view on the SEC in effect neutralizing the liability rule is opposite yours despite my conclusion being the same.

One of the things corporate issuers and underwriters pay for is the right to use NRSRO ratings in regulatory filings. If such use no longer has real value, issuers/underwriters will reduce or stop paying for them. Which erodes the authority and monopoly pricing power of the CRAs.

I.e, the SEC could have done two good things: Either enforce the liability rule strictly or stop enforcing requirements for NRSRO ratings, and about 50 bad things, most of which you can imagine and all which entail the CRAs having their losses socialized and their profits privatized. As long as the SEC did one of the two good things, I’m satisfied.

42

Watson Ladd 08.07.11 at 1:48 pm

The assumption seems to be that the downgrade is not justified. Well, probably not in financial terms, but the latest debt ceiling kerfuffle has increased the probability the US defaults out of pure bloody-minded stupidity. If you overhead a creditor arguing about whether or not to pay you back, you would be worried no matter how much money they had.

43

Matthew Yglesias 08.07.11 at 2:26 pm

What happens to things like Basel standards under the Quiggin Plan?

It seems to me that the Dodd-Frank solution of turning the agencies into legally liable “experts” is the correct one. This isn’t being implemented because House Republicans won’t implement the funds needed to implement it. But by the same token, I think we can assume they won’t agree to any other major reform.

44

Asteele 08.07.11 at 2:34 pm

Luckily, the intransigence of the Republican party isn’t something that the rest of the world would have to worry about, if they moved away from the current model.

45

P O'Neill 08.07.11 at 2:44 pm

If S&P is now claiming, in response to the $2 trillion error, that they rate based on trajectories rather than levels, then the time to downgrade the USA was 2006, when it was 2 unfunded wars, Medicare expansion, and an objective of permanent tax cuts setting the trajectory of US debt. Maybe all the people who should have been watching the sovereign debt at that time were too busy with the structured debt ratings.

Anyway the appetite for rating agency reform may be bigger tomorrow when we see how far beyond agency debt tomorrow’s additional downgrades extend.

46

jpe 08.07.11 at 3:12 pm

Aren’t the legal cutlets typically much lower, in the BB+ range? What is an example of an institution legally required to hold only AAA bonds?

I second this question. I’ve looked into this since Friday night a bit, and haven’t found any examples of institutional investors required to hold a given amount of top-rated bonds. As this commenter notes, the threshold for the rating is really quite a bit lower. When pensions even require a rating (CALPERS doesn’t appear to, for example, but instead relies on its own judgment of prudence). I’ve looked for guidelines for other institutional investors but haven’t found anything to confirm the claim that only top-rated debt can be held.

47

christian_h 08.07.11 at 3:12 pm

This isn’t particularly difficult. CRA are supposedly in one business and one business only: judging default risk. Since the US, having a fiat currency, cannot actually default (unless by choice and that will not in fact happen this side of the revolution), they should not be in the business of rating their debt, period. They are not “inflation ratings agencies”, after all.

One concludes – and this is backed up by reading the crap their analysts have come out with – that this is a naked political power play aimed at forcing more austerity on the American worker. As Bob McManus posted above, the correct answer would be to destroy S&P and make an example.

48

Watson Ladd 08.07.11 at 3:16 pm

@christian_h: What was going to happen with no deal? Default! A nation might always be able to avoid default by printing money, but might not want to as inflation screws over domestic constituencies as well. The antics of the Congressional Republicans make it clear that no matter how avoidable default may be, it just might happen.

49

christian_h 08.07.11 at 3:21 pm

There was never going to be “no deal”, it was all theatre. But this doesn’t even matter – S&P did not claim their downgrade came as a judgement of probabilities of future insane TP behaviour, but as a warning that more austerity was needed and the budget deficit should be further reduced. Since there is no level of budget deficit that can lead to default, this makes no sense.

50

Ed 08.07.11 at 3:33 pm

Since the US, having a fiat currency, cannot actually default

That’s not true. It’s something that is repeated a lot in blogs but it is false.

51

shah8 08.07.11 at 3:35 pm

I view the problem as exogenous to the rating agencies.

The problem is with the ease that the big players have with foisting losses onto their embedded society with Ireland being the classic example.

If you make losses hard to avoid, and practical restructuring mandatory on the sight of a bad book, then you’ll have demand for honest ratings agencies.

No honest financiers==no demand for honest rating, and high demand for dishonest ratings.

52

christian_h 08.07.11 at 3:41 pm

Ed (49.): Actually, a lot of economists say so, and not only in blogs. So I’ll have to withhold judgement over accepting the perfunctory claim by an anonymous person in a blog comment over theirs.

53

Barry 08.07.11 at 3:45 pm

Andrew F: “I’d much rather a large financial institution be liable than attempt to sue the government for shoddy investment advice.”

Um, if there was any significant ability for people defrauded by the ratings agencies to sue, those agencies would be bankrupt by now.

Please don’t suggest solutions which have clearly failed.

54

Ginger Yellow 08.07.11 at 3:48 pm

– S&P did not claim their downgrade came as a judgement of probabilities of future insane TP behaviour

Actually they did. They explicitly listed Republican unwillingness to raise taxes, exemplified in the debt deal’s lack of revenue measues, as a key reason for the downgrade, .

55

Earwig 08.07.11 at 3:55 pm

Agreed, P O’Neill — Given the explicit ‘reasoning’ provided by S&P, the timing of this downgrade action should certainly raise many questions. I find myself unable to avoid concluding as christian_h does “that this is a naked political power play aimed at forcing more austerity.”

Ed, your point is taken — the US can default. However, I think the case is that if that happened it would indeed be “by choice.” To me that’s not evidence that S&P’s current rating is “wrong” — instead it seems another pointer toward the coherence of the political action theory. Obama’s lawyers notwithstanding, would a “by choice” default have any possibility of not conflicting with the 14th amendment?

56

Paul 08.07.11 at 4:02 pm

Re Ed @ 49…
someone said “Since the US, having a fiat currency, cannot actually default”

Ed replied…”That’s not true. It’s something that is repeated a lot in blogs but it is false.”

How can a monetary sovereign nation with a fiat currency system default?

57

ejh 08.07.11 at 4:02 pm

Isn’t William Goldman actually a better guide than the ratings agencies?

58

jpe 08.07.11 at 4:03 pm

They are not “inflation ratings agencies”, after all.

Inflating away debt is just a partial default for a holder whose functional currency isn’t USD. It would be absurd not to factor inflation risk into a credit rating when assessing sovereign debt. And, IIRC, S&P does exactly that. Or: they are, in fact, inflation ratings agencies.

59

ejh 08.07.11 at 4:05 pm

(On reason for my cynicism about the agencies is that they seem to me to be in the happy position – happy for them – of being able to influence events with their own predictions.)

60

Lemuel Pitkin 08.07.11 at 4:05 pm

They explicitly listed Republican unwillingness to raise taxes, exemplified in the debt deal’s lack of revenue measues, as a key reason for the downgrade,.

Not to belabor the obvious, but as long as the US borrows in dollars, it is literally impossible for a failure to raise taxes to cause a default. Inflation, in principle, yes. But if S&P were incorporating inflation risk, they’d have to downgrade every other dollar issuer as well.

To claim that the debt-ceiling circus should raise our subjective probability of a deliberate default by the US government is defensible, altho not one I think S&P should be making. But the claim that the probability of default depends on decisions about tax and spending levels, which I’m afraid you seem to share, is incoherent. It’s just a non sequitur.

61

Ed 08.07.11 at 4:08 pm

How can a monetary sovereign nation with a fiat currency system default?

By choice. There are many examples in the historical default studies.

Not to belabor the obvious, but as long as the US borrows in dollars, it is literally impossible for a failure to raise taxes to cause a default.

Incorrect. There are many examples of nations defaulting on their own currency.

62

Paul 08.07.11 at 4:12 pm

The word “default” implies “no choice” i.e. “unable” to pay the bills. The U.S has never been in a position where it was unable to pay it’s bills. Nor can it ever be.

You are perpetuating an idea that has no basis in fact but presents itself as a real world problem.

In other words you are making things up.

63

Earwig 08.07.11 at 4:13 pm

We can make a political decision to default. Maybe we almost did (I don’t think so, but maybe). We’ll have to violate our constitution to do it, but what impediment would that be, really? — a Democratic President seems perfectly willing to ignore it. “Let’s establish a norm of austerity, then I’ll step out into the sunlight to mouth some very weak jobs talk. The rubes’ll buy anything.”

64

Lemuel Pitkin 08.07.11 at 4:14 pm

Also, I still want to know what specific institutions would have to reduce their holdings of Treasury securities if another agency dropped its AAA rating. I’m skeptical that this factor is as important as lots of people, including John Q. in the original post, are asserting.

From Forbes:

US Treasurys are an exception to the AAA covenant that money market and pension funds have regarding bonds. In almost every money market fund prospectus, pension fund investment policy statement and bond mutual fund prospectus in the US they usually treat US Treasurys differently from other bonds. That means that there will be no forced selling of Treasurys in order to honor the funds’ covenants, says Paul Dietrich, managing director of Foxhall Capital Management in Orange, Conn.

65

Ed 08.07.11 at 4:16 pm

The word “default” implies “no choice” i.e. “unable” to pay the bills.

Incorrect. To default is to not pay on time as originally agreed. It can be because they are unable or because they are unwilling.

66

Lemuel Pitkin 08.07.11 at 4:16 pm

There are many examples of nations defaulting on their own currency.

Read what I wrote. I didn’t say default was impossible, I said a default caused by insufficient tax revenue was impossible. Of course any governments can choose to default.

67

Ed 08.07.11 at 4:17 pm

Lemuel,

I agree.

68

Paul 08.07.11 at 4:26 pm

“Incorrect. To default is to not pay on time as originally agreed. It can be because they are unable or because they are unwilling.”

Baloney. No sane person/entity would voluntarily default on their obligations if they had the ability to pay.

A business would not voluntarily default on it’s obligations – that would mean bankruptcy. Suicide. You are implying it’s OK for our leaders to act like children and make terrible decisions. Another case of Stockholm Syndrome.

If it weren’t for a silly law passed a hundred years ago when we were on the Gold Standard the U.S. would not have to issue Treasuries dollar-for-dollar with deficit spending, creating a windfall for bond-traders which have no real function in our monetary system.

69

hartal 08.07.11 at 4:30 pm

“Father [S&P], our heart breaks for America,” Texas Governor Rick Perry said as he led the crowd in prayer. “We see fear in the marketplace. We see anger in the halls of government and as a nation, we have forgotten who made us, who protects us, blesses us, and that we cry out for your forgiveness.”

70

Ed 08.07.11 at 4:31 pm

No sane person/entity would voluntarily default on their obligations if they had the ability to pay.

Once again, incorrect. In fact almost all sovereign defaults are ‘by choice’. See this for some more color: http://blogs.reuters.com/felix-salmon/2011/08/06/the-credibility-and-integrity-of-sp's-ratings-action/

71

Bruce Wilder 08.07.11 at 4:35 pm

The political precedent set by the debt ceiling “crisis” makes an eventual default by the U.S. a very high risk. Default is now the desired policy of a significant fraction of, at least, one of two political parties in the U.S. They will find a way to default.

The MMT folks seem to have pressed home half an insight on the nature of a fiat currency: the sovereign can print more, and the sovereign’s ability and willingness to collect taxes in the currency is a support for the currency’s value.

The other half of the insight, obscured too often, is that a fiat currency is back by demand for real goods. It is the expectation that there are goods, which can purchased with the currency, which gives the currency, value, sometimes expressed by the quip that Bernanke can print dollars, but not oil. The U.S. is rapidly disinvesting, beneath the cloak of its insane financialization, and its global empire is teetering on the edge of collapse. If S&P had included this view in its analysis, its opinion would have been exciting reading.

72

Paul 08.07.11 at 4:38 pm

“Once again, incorrect. In fact almost all sovereign defaults are ‘by choice’. See this for some more color: http://blogs.reuters.com/felix-salmon/2011/08/06/the-credibility-and-integrity-of-sp's-ratings-action/

I like Felix but he’s not my God. If a sovereign defaults it is choosing to be bankrupt and start all over. Argentina maybe. U.S. “debt” is 99.99% in U.S. dollars, so I don’t know how we could even declare bankruptcy since we are the monopoly issuers of the currency.

Countries that have “chosen” to default have had significant holdings of foreign currencies. We don’t and never will.

Maybe it is you that is mistaken.

73

Ed 08.07.11 at 4:41 pm

We don’t and never will.

That’s your opinion. That’s OK.

74

Zamfir 08.07.11 at 4:43 pm

Paul, the reason that businesses do not voluntarily default is that the legal bankruptcy procedures are set up to take control and all remaining assets of such a business out of the owners hands. A higher authority explicitly enforces that default is not attractive.

That’s not relevant for sovereign debt, which has by definition no higher authority that could enforce such procedures (although the IMF etc. are arguably a weak version of it, but the US of course doesn’t have to fear loss of sovereignity).

Reputation damage is the only (but big) thing sovereigns have to fear in a default. That could mean they still hand over some assets and control to external parties (like the IMF), as part of an attempt to manage the reputation loss. But that step would be voluntary, especially for the US.

75

hartal 08.07.11 at 4:43 pm

The Chinese government jumped on the downgrade and demanded protection of its dollar assets. QE, coupled with the monetization that more debt would likely require, has raised the specter that the Chinese government would diversify out of its dollar holdings or retaliate in some way. Robert Rubin who was guiding Obama through his acolytes has openly and repeatedly spoken over the last year of the need to get the US fiscal house in order to make sure confidence in the dollar (and the trade in dollar-denominated assets) remains strong. A one-two punch from the Chinese government and Goldman Sachs seems to have given the S&P the confidence to issue a historic downgrade of the most powerful state in the world.

76

Paul 08.07.11 at 4:45 pm

I said “We don’t and never will.”… Ed replied “That’s your opinion. That’s OK.”

Is it a fact or my opinion that the U.S. has no significant holdings in foreign debt?

Why will we ever need to borrow in foreign debt?

77

Ed 08.07.11 at 4:49 pm

Zamfir,

Yes, I agree. That’s why they are called ‘sovereigns’ after all.

Paul,

If you think that the US will never choose to default, that’s your opinion and that’s OK. If you think that it is literally impossible for the US to default, then you are incorrect.

78

Paul 08.07.11 at 4:50 pm

Zanfir @ 71

How would damage to the U.S. reputation hurt the U.S. vis-a-vis financing our government operations?

What control does the IMF have over the operations of the U.S. government?

79

Bruce Wilder 08.07.11 at 5:08 pm

Zamfir @71

Businesses do voluntarily default all the time. On what planet have you been asleep?

And, there are provisions of the bankruptcy code, which allow the management to retain control of the business, which are, of course, the provisions most often used.

80

Walt 08.07.11 at 5:23 pm

hartal, if China diversified away from dollar holdings, that would be all to the good for the US, since it would push down the dollar and make US exports more competitive.

81

hartal 08.07.11 at 5:43 pm

One would need much more careful argument to show that the positive effect on net exports would outweigh the negative effects from possibly higher interest rates in such a highly leveraged economy; moreover, US exports don’t depend as much on the relative value of the dollar as the strength of accumulation abroad on which dollar devaluation would have little effect. Lastly, the industries in which the US has a quasi monopoly position would actually stand to lose from a weaker dollar.

82

BertCT 08.07.11 at 6:12 pm

This is more to do with S&P, though it’s likely endemic to the industry: investigate them for insider trading. Seemingly lost in all the political circular firing squads of blame is an interesting tidbit about S&P’s numbers. Multiple reports cite S&P admitting their numbers were bad – by the trillions – but they decided to go ahead with their downgrade because they had already notified some of their clients they were making the change.

Last I checked, if in the course of your work you had confidential information about a future material change affecting a publicly traded security, you are required to keep that information confidential, and you were not allowed to act on it to your own benefit, or the benefit of others. S&P had that information, and shared it with clients before making it public. Further compounding the malfeasance, they then acquired MORE information (the US government figures) showing their information incorrect, but did nothing to amend their errors. This was done to protect their clients, who had already acted on their insider information, and a revision would have caused them to lose money. So on top of insider trading, they perpetrated a blatant fraud to protect their “insider” clients.

Where’s Eliot Spitzer when you need him?

83

Lee A. Arnold 08.07.11 at 6:16 pm

What a difference a downgrade makes!

Before: Obama caved and didn’t stick to principles; most of his party furious with him.

After: the Tea Party is so uninformed and politically uncompromising as to be un-American. On every non-Murdoch medium.

If they had accepted Obama’s offer, all would have been well (S&P report, page 4, bottom). And the Tea Party would have been in brilliant political shape.

It will soon be realized by everyone with a functioning brain that the Boehner-Cantor-Teas own the debacle.

Only 2 questions remain: (1) How long before senior Republicans start leaving their party; and (2) How long before the Limpbagh-Murdocracy enters a terminal psychological crisis.

Historically, the end of Republican Party.

Next up, for those concerned about the future of the United States: SHORT-TERM SPENDING IS NOT THE LONG-TERM PROBLEM. Government planning is necessary for healthcare.

84

hartal 08.07.11 at 6:22 pm

That post, Lee A. Arnold, is a home-run!

85

Lemuel Pitkin 08.07.11 at 6:26 pm

Most empirical studies of US trade and exchange rates find an export price elasticity of between 0.5 an 1.0, i.e. a one percent devaluation boosts US exports by between half a percent and one percent. Measured import elasticities are much lower — always less than 0.25, and not significantly different from zero in many studies — mainly because most exchange rate changes are not reflected in the dollar price of US imports. A typical estimate of exchange-rate passthrough would be around 0.3 — that’s what the OECD uses in its standard macro model (and it’s also what I found when I looked at this for my dissertation, which I really should be working on now instead of commenting here.) Put those together with current trade flows, and you find that a 20 percent dollar depreciation (about the largest one can realistically imagine) gives a boost to US net exports of between 1.5 and 2 percent of GDP, spread out over two or three years. That would probably reduce unemployment by between half a point and a point — not a trivial improvement, but not a big one either. On the other hand, that assumes that a dollar depreciation wouldn’t lead to slower growth, lower inflation or lower real tradables-goods wages in US trade partners — something that can’t be taken for granted.

On the other hand, changes in the bilateral US-China exchange rate would have no macroeconomic benefit at all.

I discussed these issues a while back in some posts on my blog (the older ones especially).

86

BertCT 08.07.11 at 6:28 pm

Let me try and say that better:
If the course of your work WILL cause a future, material change in the value of a security…

After all, it’s a stockbroker’s job to let his clients know about possible changes to the value of securities. But S&P ain’t a broker.

87

hartal 08.07.11 at 6:29 pm

LP,
I was relying on a paper by Warner and Sachs on the effects of dollar devaluation on exports. It had been cited by James Galbraith, and I ran it down. It’s an old paper. I read it ten years ago.

88

Lemuel Pitkin 08.07.11 at 6:30 pm

hartal-

You might be less impressed if you’d been reading CT longer. Lee A. Arnold has been informing us of the imminent collapse of the Republican Party since at least 2006. It’s kind of sweet — there aren’t too many Dem fanboys these days — but lacks informational value.

89

Ed 08.07.11 at 6:33 pm

they decided to go ahead with their downgrade because they had already notified some of their clients they were making the change

Completely false and made up.

90

Lemuel Pitkin 08.07.11 at 6:35 pm

There’s a big literature on this and the estimates are fairly consistent. It’s hard to find an estimate of the exchange rate elasticity of US exports that isn’t between 0.5 1, or of US imports that’s not between 0 and 0.25 These seem fairly stable over time (as does the Houthakker-Magee asymmetry that the income elasticity of US exports is about 2/3 that of the income elasticity of US imports.)

I should add, re the other thread, that these are exactly the sort of things that people who study macroeconomics in programs that emphasize DSGE approaches never think about. Their whole training teaches them to pay no attention to relations between aggregates.

91

Watson Ladd 08.07.11 at 6:36 pm

BertCT: If you think that, you have some free money to pick up. I don’t think the market budged, thanks to the weirdness that is a liquidity trap, but if people were listening to S&P under normal conditions it would have and you could have made some money. Why would you tell us about market manipulation? Furthermore S&P is no different then any analyst: they cannot self deal, but (IANAL) there’s nothing that stops you from having a first tier and second tier of customers.

92

dsquared 08.07.11 at 6:54 pm

1. Ratings have generally a good record, as evidenced by annual defaults studies. This includes sovereign ratings. The one huge exception are the MBS ratings of the mid 2000s.

Ed, this probably isn’t the right blog to be trying to get away with the “notably rare exceptions” gambit.

93

Ed 08.07.11 at 6:57 pm

It’s not a gambit.

If you want to understand ratings you need to understand that they have a pretty good track record. Why they failed the way they did on recent MBS (but not on previous MBS, for example) is an interesting topic and if there is ever a thread on this I may post my views.

94

Lee A. Arnold 08.07.11 at 7:06 pm

Lemuel @85, Politics entirely lacks informational value, except in an emotional-rhetorical sense. That, however, turns out to cover almost everything in this case, and is likely to predominate the causes for the eventual economic effects of this sovereign rating downgrade.

But first, please explain how an historical prediction could in this case make a deterministic difference among the years 2006, 2011 (i.e. now), and 2015 (let’s say). We ought to know more about complex systems than we do, and your insights will be appreciated.

I wildly guessed that the Republican implosion would begin around 20 years after Reagan — so by the year 2000, my prediction having not come true, I started to pay closer attention, and I confess that the implosion seems to be accelerating.

Of course, they could attempt to make amends: you may have noted that today Paul Ryan is grumbling that more revenues might be necessary! An astounding turnabout. Perhaps he is called upon to pay attention to relations among aggregates. And indeed, he realizes that it is too late: they made a big mistake.

95

Andrew F. 08.07.11 at 7:12 pm

Barry @51: Um, if there was any significant ability for people defrauded by the ratings agencies to sue, those agencies would be bankrupt by now. Please don’t suggest solutions which have clearly failed.

No Barry, you’ve misread my comment at 34. The point is that by shifting responsibility from investment managers to a regulatory agency one deprives investors of the means to sue the managers.

And investment managers have been sued very successfully.

Lemuel @61: Also, I still want to know what specific institutions would have to reduce their holdings of Treasury securities if another agency dropped its AAA rating. I’m skeptical that this factor is as important as lots of people, including John Q. in the original post, are asserting.

It is frequently the case that US Government backed debt is explicitly noted as an approved type of security for a given allocation in various agreements; and that elsewhere it is explicitly noted as an approved type of collateral.

And even where that is not the case, generally being rated at the highest level by at least two of big three is a qualifying feature – which is why Quiggin is concerned about a second downgrade.

Still, one suspects that not all agreements explicitly name US Government backed debt, and that a second downgrade might prompt a rewriting of those that do.

96

Cranky Observer 08.07.11 at 7:31 pm

> It is frequently the case that US Government backed debt is
> explicitly noted as an approved type of security for a given
> allocation in various agreements; and that elsewhere it is explicitly
> noted as an approved type of collateral.

And regardless of what letters S&P claim apply to US Treasury bonds, what exactly are the alternatives? Greek government debt? Credit default swaps on the euro? Some sort of instrument based on, well, something of defined value in the PRC that investors have some sort of assurance will still exist in 10 years and won’t be confiscated or subverted? I’m not seeing a lot of possibilities here.

Cranky

97

dictateursanguinaire 08.07.11 at 8:12 pm

“How can a monetary sovereign nation with a fiat currency system default?

By choice. There are many examples in the historical default studies.”

Surely, you understood what the OP meant when s/he said “cannot default” as in “cannot be forced to” vs. “would never choose to.” Who on Earth believes that there is some sort of metaphysical constraint on gov’ts so that they are literally incapable of choosing default? Obviously, what the OP meant is that nations which print their own currency can’t default due to constraints on borrowing or lack of export earnings — and you know that. Why do you insist on making cutesy, bad-faith arguments based on grammatical errors? This is starting to seem like trolling.

98

dictateursanguinaire 08.07.11 at 8:13 pm

*grammatical errors in other people’s postings.

99

bob mcmanus 08.07.11 at 8:18 pm

Lee Arnold could very well be right about the imminent collapse of the Republicans.

But like a prediction of the collapse of Southern chattel slavery say around 1850, Arnold might be slightly underestimating the challenges of the transition phase and the collateral damage.

100

Ed 08.07.11 at 8:21 pm

Since no one here has argued that the US could be forced to default I fail to see the relevance of your comment.

101

Barry 08.07.11 at 8:48 pm

Zamfir 08.07.11 at 4:43 pm

” Paul, the reason that businesses do not voluntarily default is that the legal bankruptcy procedures are set up to take control and all remaining assets of such a business out of the owners hands. A higher authority explicitly enforces that default is not attractive.

That’s not relevant for sovereign debt, which has by definition no higher authority that could enforce such procedures (although the IMF etc. are arguably a weak version of it, but the US of course doesn’t have to fear loss of sovereignity).

Reputation damage is the only (but big) thing sovereigns have to fear in a default. That could mean they still hand over some assets and control to external parties (like the IMF), as part of an attempt to manage the reputation loss. But that step would be voluntary, especially for the US.”

The economic catastrophe which would sweep the world into something where the Great Depression looks like paradise would be an obvious deterrent. Now, the TP doesn’t know/doesn’t care. However, Wall St and the elites of Big Oil would.

102

John Quiggin 08.07.11 at 8:53 pm

The AAA requirement is mainly for money market funds and similar:

http://www2.goldmansachs.com/gsam/glm/education/guide-to-mmf/first-and-second-tier/index.html

There’s a much lower standard of “investment grade” securities (those outside this class are “junk bonds”).

103

Lemuel Pitkin 08.07.11 at 9:22 pm

Surely, you understood what the OP meant when s/he said “cannot default” as in “cannot be forced to” vs. “would never choose to.”

Right. And just to complete the thought, the importance of the distinction is that the probability of being forced to default is closely related to your ability to raise sufficient funds through taxation to cover expenditures, and the size of the existing debt. The probability of a default by choice is not closely linked to those factors. So the S&P’s stated reasons for the downgrade would make sense for a private borrower or sovereign borrowing in a foreign currency, but are largely irrelevant for the US.

The AAA requirement is mainly for money market funds and similar: http://www2.goldmansachs.com/gsam/glm/education/guide-to-mmf/first-and-second-tier/index.html. There’s a much lower standard of “investment grade” securities (those outside this class are “junk bonds”).

OK. And yes, I know the distinction between investment-grade and junk status — the lower limit of the former is generally considered to be BB+, as I mentioned upthread. However, I have the impression that most MMFs and the like have an explicit exception for US federal debt.

I continue to believe that the only long-term effect of this downgrade will be demonstrate the irrelevance of the rating agencies to demand for US debt, and by extension the absence of financial constraints on US fiscal policy. In that sense — to go all Lee A. Arnold for a moment — I think it is clearly a positive development.

104

Ed 08.07.11 at 9:26 pm

So the S&P’s stated reasons for the downgrade would make sense for a private borrower or sovereign borrowing in a foreign currency, but are largely irrelevant for the US.

Incorrect. The US can default, even if it issues in its own currency. The idea that sovereigns that borrow in their own currency don’t default is one of those zombie memes that just won’t die.

And a small side note. It’s not “the S&P”. That’s the index. The ratings company is just S&P, without the “the”.

105

Ed 08.07.11 at 9:27 pm

I know the distinction between investment-grade and junk status—the lower limit of the former is generally considered to be BB+

Sorry, wrong again. Investment grade is BBB- and higher (Baa3 in Moody’s scale). Junk is anything below that.

106

Lemuel Pitkin 08.07.11 at 9:33 pm

Incorrect. The US can default, even if it issues in its own currency. The idea that sovereigns that borrow in their own currency don’t default is one of those zombie memes that just won’t die.

Wow, you’re really bad at reading comprehension, aren’t you? What I wrote is that for non-sovereign borrowers, the probability of default is closely linked to the relationship of revenue and expenditure and the size of the existing debt stock. For sovereign borrowers, where default is a political choice, its probability is not closely linked to those factors. So the stated reasons for the downgrade are not relevant in the case of the US.

If you want to get rid of zombie memes, you might want to start with the ones in your own head.

And a small side note. It’s not “the S&P”. That’s the index.

Yup, my bad. And you’re right — I meant to say that BB+ is the upper limit of junk status, not the lower limit of investment-grade.

107

Ed 08.07.11 at 9:40 pm

What I wrote is that for non-sovereign borrowers, the probability of default is closely linked to the relationship of revenue and expenditure and the size of the existing debt stock. For sovereign borrowers, where default is a political choice, its probability is not closely linked to those factors. So the stated reasons for the downgrade are not relevant in the case of the US.

Not true. The more debt you have the more likely you are of defaulting, all other things equal. This is true for both local and foreign currency debt. Of course, the breaking point, the point at which a government decides to default, will vary by country and by institutional setting (and vary a lot). But no sovereign credit analyst, be they at a rating agency or someplace else, will ignore debt ratios simply because a government’s debt is all in local currency.

108

Lee A. Arnold 08.07.11 at 10:45 pm

Bob @99 — I cannot imagine underestimating the challenges. But these things don’t happen by themselves. The Republican implosion is partly preprogrammed (by self-contradictory ideology in the face of scientific reality), but partly it will be caused to happen. The way you do that is through rhetoric; politics is a team sport that is played on the field of rhetoric. And you may be able to help people. If it weren’t involved in wars and death and people trying to put food on the table, politics wouldn’t be much different than professional sports. On Crooked Timber I like to report the political moment, especially on John Quiggin’s posts, because I am pretty sure he senses the ironies involved in a subject which is rightfully called Political Economy. I usually only post once; I don’t otherwise harp on politics because of course lots of people don’t like it. What I don’t understand is personal animus and misinterpretation by other commenters. It sounds like other people are frustrated because they are as ineffectual as I am.

P.S. Of some import as to what to do about ratings agencies, here is “Competition” (1:30), just completed:
http://www.youtube.com/user/leearnold#p/c/CAE3CA6D964BFC8E/20/of_69G1X5Co

109

jpe 08.07.11 at 10:57 pm

The AAA requirement is mainly for money market funds and similar

Per the SEC rules, though, “first tier security” includes “any government security.” (2a-7(14(iv)).

So I don’t see how this will force a sell off.

110

John Quiggin 08.07.11 at 11:04 pm

@jpe As in the original post, the problem is that other countries have similar rules, in which their own government securities are treated as safe, but not second-tier countries like the US :-)

111

Lori C. Burch 08.07.11 at 11:36 pm

I think the solution is simple; take rating agencies at their word. When they say that they just collect some data and offer opinions, give them exactly as much credence as anyone else who just collects data and offers opinions.

This should obviously apply to legislation as well.

But if a financial institution wants to outsource its credit department, let them, to some institution which accepts liability – i.e. which is not a CRA. Currently the “regulator and taxpayer” are effectively acting as a deposit insurer for our banks. Let that continue for a tightly defined and well understood collection of loan classes, e.g. resi mortgage. But for other loans, an outsourced credit department should also have outsourced capital.

112

James Wimberley 08.08.11 at 12:12 am

Comment 111, and I’m the first (SFIK) to make the obvious point that the ratings business is far too concentrated: just three American companies with the same Wall Street perspective.. Competition in ratings might be more effective if there were at least 10: five in the USA, two in Europe, one each in in China, Japan and Brazil. Or perhaps the UAE sheiks might stump up for the prestige, as with Al-Jazeera.

113

Ed 08.08.11 at 12:15 am

Actually there are many rating agencies. And Fitch is French owned and based out of London.

114

hartal 08.08.11 at 2:04 am

S&P issued the downgrade because that is what Wall Street wanted, and Wall Street wanted it because that is what the Chinese actors with whom it wants to continue to do business inside and outside China wanted. Rubin once called up the Treasury to put pressure on the credit agencies not to downgrade Enron. This time Wall Street served as the agent of the international bond market and S&P played its role.

115

rwschnetler 08.08.11 at 3:17 am

@114 : WTF?

Sanity has left the building.

116

hartal 08.08.11 at 4:04 am

Obama wanted $400 billion dollars worth of debt reduction through entitlement cuts and the closing of tax loopholes. He clearly wanted that because Rubin had convinced him that fiscal conservatism stimulates the economy by making the international bond markets happy, and the major player in the international bond markets are the Chinese who have been quite loud about US fiscal irresponsibility leading to the devaluation of their dollar denominated assets .

Obama did not have to make debt reduction a condition of lifting the debt ceiling. He could have tied that to the extension of the Bush tax cuts, which is the only thing the Tea Party cares about. Obama wanted to use the debt ceiling deadline as a pressure on both parties to make a deal for long-term debt reduction, and he wanted long term debt reduction because he was convinced by Rubin that the best way to stimulate the economy is by keeping the international bond markets happy.

Moreover, both Rubin and Obama believe that there cannot be long term debt reduction without long term growth which depends on tax-financed infrastructural investment; that is why they are both for the estate tax, higher marginal rates and closing of tax loopholes.

At any rate, to keep the international bond market happy there was no talk of a second stimulus. And to continue to keep it happy, Rubin and Obama believe probably for good reason that the US must have a credible long term debt reduction plan.

117

Cranky Observer 08.08.11 at 12:12 pm

> Moreover, both Rubin and Obama believe that there cannot be
> long term debt reduction without long term growth

Please note that since 2001 the United States has undertaken 3 wars, has borrowed every dollar spent in undertaking those wars, and has _cut_ its tax rates three times. The income tax increases that would be needed to pay for those wars and – wait for it – reduce the debt! – would be very very modest compared to the tax rates during WWII and the Korean War, and would in no way affect “long term growth”. In fact, demonstrating to the world and “the markets” that we are mature enough to pay for what we buy would very likely provide that reduction in uncertainty that everyone is hoping for.

So let’s not go down the Norquist path of assuming that cuts in badly needed federal programs are the only way to reduce the debt.

Cranky

118

Barry 08.08.11 at 12:50 pm

Ed 08.07.11 at 7:18 am

” To simplify, here are my points:

1. Ratings have generally a good record, as evidenced by annual defaults studies. This includes sovereign ratings. The one huge exception are the MBS ratings of the mid 2000s.”

From http://www.nytimes.com/2011/08/08/opinion/credibility-chutzpah-and-debt.html?smid=tw-NytimesKrugman&seid=auto

“More broadly, the rating agencies have never given us any reason to take their judgments about national solvency seriously. It’s true that defaulting nations were generally downgraded before the event. But in such cases the rating agencies were just following the markets, which had already turned on these problem debtors.

And in those rare cases where rating agencies have downgraded countries that, like America now, still had the confidence of investors, they have consistently been wrong. Consider, in particular, the case of Japan, which S.& P. downgraded back in 2002. Well, nine years later Japan is still able to borrow freely and cheaply. As of Friday, in fact, the interest rate on Japanese 10-year bonds was just 1 percent. “

119

Steve LaBonne 08.08.11 at 12:57 pm

Reality check on the basic competence level of S&P. I love the bit about the managing director who didn’t know grade-school arithmetic.

120

hartal 08.08.11 at 12:57 pm

Krugman writes at his blog: “I’m fairly sure that if and when we get the whole story here, it will turn out that S&P was being political here, trying to do someone a favor — and it just wasn’t going to let facts get in the way of the downgrade it wanted.”

Exactly. For whom was S&P doing a favor?

121

dsquared 08.08.11 at 1:09 pm

If you want to understand ratings you need to understand that they have a pretty good track record.

Not really no. With emerging market sovereigns, they have a pretty good track record of being no more than six months behind the market. With developed sovereigns, they have a pretty bad track record of doing things like giving Ireland a AAA rating, downgrading Japan (with no very obvious market consequences), upgrading Iceland right at the top tick, and now this.

122

Watson Ladd 08.08.11 at 1:14 pm

@Steve: Good article! I think I’ll now wait for Moody and Fitch, and now I know why Buffet described the rating agencies as a natural duopoly.

123

Watson Ladd 08.08.11 at 1:17 pm

@Barry: Isn’t this just an application of the EMH. Since sovereign ratings are made on the basis of public information, the markets have to anticipate them.

124

Ed 08.08.11 at 1:20 pm

Not really no.

Yes really yes. I suggest you read the IMF report and the default studies. The purpose of ratings is to rank order risk and they do that quite well.

Not sure why people insist on disproving probabilities by citing single events.

125

William Timberman 08.08.11 at 1:32 pm

For whom was S&P doing a favor?

I do wonder. One of the things about this lunacy that’s puzzled me the most is why, given the President’s servile capitulation to Goldman Sachs, et al., is there such a visceral campaign of hatred against him? Part of it is race, I suppose, despite denials all around, and part of it is undoubtedly paranoia about socialists like Van Jones or Elizabeth Warren lurking somewhere in the wings, looking for an opportunity to do collectivist evil, but surely someone who plays golf with John Boehner deserves at least a little credibility from the malefactors of great wealth.

Do they really think that they can elect the worry-free Mitt Romney next time around? Do they really discount the possibility that they might wind up with Michele Bachmann bossing them around? I’m sure that the Krupps and the Bayers were just as confident back in the day. Perhaps whoever is benefitting from S&P’s favors should ponder that for a while.

126

dsquared 08.08.11 at 1:43 pm

The purpose of ratings is to rank order risk and they do that quite well.

No they don’t and no it isn’t. The purpose is to provide information above and beyond what was already available and priced in, which ratings agencies don’t do, and they don’t rank particularly well at all (especially among investment grade credits, where there is actually no differentiation at all between the default rates of sovereigns rated AAA, AA and A). And “citing single examples” is all there is ever going to be in the developed-market world because there aren’t many first world sovereigns, so there aren’t many rating decisions to make, and the rating agencies, when given the chance (ie, Iceland, Ireland, Japan and now the USA) tend to get them wrong. I have, guess what, read that IMF study and wasn’t impressed. All the differentiation is in the sub investment grade countries, and there all it is really saying is that the ratings agencies did not completely fail to notice the 1980s and 1990s debt crises.

127

dsquared 08.08.11 at 1:47 pm

Meanwhile, the markets have spoken and their assessment is “meh”.

http://krugman.blogs.nytimes.com/2011/08/08/what-if-they-announced-a-downgrade-and-nobody-cared/

128

Lemuel Pitkin 08.08.11 at 2:00 pm

demonstrating to the world and “the markets” that we are mature enough to pay for what we buy would very likely provide that reduction in uncertainty that everyone is hoping for.

Left confidence-fairyism is just as silly as right confidence-fairyism.

I reckon businesses considering investment are asking three questions:

1. Am I fully utilizing my existing capacity, or will I be soon?

2. Do cost and competitive conditions allow me a reasonable markup of selling price above cost, and will they continue to do so?

3. Can I finance additional fixed assets?

If the answers to all three are Yes, you invest. Otherwise not. The “maturity” of people in Washington does not enter into it.

129

Ed 08.08.11 at 2:01 pm

The purpose is to provide information above and beyond what was already available and priced in,

Sorry, you don’t get come up with your own personal definition. What ratings are is clearly spelled out. If you don’t find them useful then you can simply ignore them.

130

Henry 08.08.11 at 2:03 pm

bq. The purpose is to provide information above and beyond what was already available and priced in, which ratings agencies don’t do, and they don’t rank particularly well at all (especially among investment grade credits, where there is actually no differentiation at all between the default rates of sovereigns rated AAA, AA and A).

I don’t know that you’d disagree with me, but I’ve always presumed that the ‘purpose’ of rating agencies was to provide a purportedly neutral evaluation, that could then serve as a focal point that markets could then coordinate around – i.e. that they actually ‘measure’ risk, in more or less the same way as Queen Elizabeth II ‘rules’ the United Kingdom.

131

understudy 08.08.11 at 2:21 pm

” Consider, in particular, the case of Japan, which S.& P. downgraded back in 2002. Well, nine years later Japan is still able to borrow freely and cheaply. As of Friday, in fact, the interest rate on Japanese 10-year bonds was just 1 percent.”

Japan’s public debt as a % of GDP has gone up nearly 75% since the downgrade. Regardless of the interest rate on Japanese debt, the risk of default is higher than 2002, simply because of the size of the debt relative to national income.

In any event, the yield is a poor indicator of credit risk when the BoJ can buy bonds at any interest rate of its choosing either directly or through the banks.

132

dsquared 08.08.11 at 2:27 pm

Nate Silver comes up with the goods on S&P ratings quality.

133

Watson Ladd 08.08.11 at 2:27 pm

@Lemuel: It’s that second question that forces investors to consider future events. That’s what is ment by confidence.

134

dsquared 08.08.11 at 2:30 pm

In any event, the yield is a poor indicator of credit risk when the BoJ can buy bonds at any interest rate of its choosing either directly or through the banks.

Well, in the sense that the yield is a poor indicator of “zero credit risk, there is no credit risk at all on Japanese government borrowing in yen”, then yes, and for that reason. But this kind of points out the silliness of playing games with credit ratings.

I’ve always presumed that the ‘purpose’ of rating agencies was to provide a purportedly neutral evaluation, that could then serve as a focal point that markets could then coordinate around

That’s a reasonable interpretation, but it presupposes that S&P ratings of developed countries have a purpose at all. In fact, IMO they don’t; they’re just a silly waste of everyone’s time. And they don’t provide a useful rank order either, as Nate’s post above explains.

135

Cranky Observer 08.08.11 at 2:32 pm

> dsquared @ 2:27
> Nate Silver comes up with the goods on S&P ratings quality.

Oh my, that’s brutal. Paired with Krugman’s more qualitative posts it doesn’t doesn’t even leave many scraps of the corpse behind.

Cranky

136

politicalfootball 08.08.11 at 2:33 pm

From the Silver article linked by dsquared:

Spain, which markets now posit has about a three-in-ten chance of default or restructuring, also had a AAA rating, which it maintained until January 2009. Today it still has a AA rating, one notch higher than Japan’s.

That looks crazy to me. Is there something I’m missing? Is there any chance at all that S&P has a better read on this than the markets?

137

Walt 08.08.11 at 2:34 pm

It’s sort of amazing how low of a bar the ratings agencies want to set for themselves. “Well, it says clearly right here that these are just some letters that felt right to us. A Ouija board may have been involved. It’s pure advisory. Just go with the flow, man!” I’m guessing that’s not part of their pitch to clients.

The whole thing has turned out much more embarrassing than I expected. I initially thought that they had some mechanical model for sovereigns, and the debt ceiling crisis gave them the courage to apply the model to the US. But after the $2 billion error, the “political favor” explanation looks like the explanation that reflects least badly on S&P.

Coming up with a rank order of sovereign default has got to be the easiest job anyone has ever given themselves in the history of the world. I bet I could come up with a purely statistical model that does as well as S&P. (In fact, I bet some economist already has such a model, somewhere out there in the billion papers on sovereign default.) Is there a convenient database of sovereign defaults?

138

Walt 08.08.11 at 2:36 pm

Right now, the headline on Yahoo Finance is “Stocks Fall as Traders React to Ratings Cut”, but it’s showing that the yield on 10-year Treasuries has dropped to 2.4%. Am I hallucinating?

139

Zamfir 08.08.11 at 2:36 pm

@Ed, it’s far from obvious that situations like this can be modelled as probabilistic events. That assumes we can see this situation as a draw from a large set of data of similar events, where the difference between those events can reasonably be assumed to be caused by independent random factors.

That’s a sort-of reasonable claim for some situations, but hardly for a default of the US. Arguably, the US has a unique economic position without any comparison in modern history, in which case our relevant data set consists of those all those other times the US did or did not default. But even if you take the set of “similar” situations broader, you are still restricted to a very small number of defaults from situations that vaguely resemble the economic situation of the current US.

That makes it highly important to look at those individual events, to decide whether they can really be included in the set to be used for probabilistic arguments.

140

Cranky Observer 08.08.11 at 2:46 pm

> In any event, the yield is a poor indicator of credit risk

So sometimes market price is a good indicator of value, and sometimes market price is not a good indicator of value. Check. Now all we need is some sort of evaluation mechanism to tell us which situation prevails for any given market trade…

Cranky

141

mpowell 08.08.11 at 2:50 pm


Japan’s public debt as a % of GDP has gone up nearly 75% since the downgrade. Regardless of the interest rate on Japanese debt, the risk of default is higher than 2002, simply because of the size of the debt relative to national income.

In any event, the yield is a poor indicator of credit risk when the BoJ can buy bonds at any interest rate of its choosing either directly or through the banks.

This extends the erroneous assumption that Japan’s default risk is significantly related to it’s debt/GDP ratio. It is a wrong assumption for Japan or the US for reasons that have been rehashed a number of times. I can only assume that people who don’t understand these arguments are missing something, but I’m not going to presume to know what it is. Based on the reputation of S&P personnel, I would assume that they are in this group. There is clearly a default risk in the United States as long as we have tea party members and a Republican majority in the House, but again, this has nothing to do with debt ratios.

142

Steve LaBonne 08.08.11 at 2:56 pm

I can only assume that people who don’t understand these arguments are missing something, but I’m not going to presume to know what it is.

There doesn’t even seem to be a thought process (however erroneous) involved, just some kind of moralistic fetish.

143

Watson Ladd 08.08.11 at 3:15 pm

@Zamfir: Have you ever heard of Bayes theorem? We can estimate probabilities for things we only see once, like the mass of Saturn being within certain ranges. Credit defaults might not be amenable to frequentist analysis, but that doesn’t mean one can’t use probability theory to analyze them.

144

Steve LaBonne 08.08.11 at 3:19 pm

Credit defaults might not be amenable to frequentist analysis, but that doesn’t mean one can’t use probability theory to analyze them.

That doesn’t remove the challenge of deciding what counts as evidence.

145

politicalfootball 08.08.11 at 3:29 pm

More from Silver, regarding European sovereign debt ratings:

S.&P.’s bond ratings from five years ago would have told you almost nothing about the risk of a default today. They had no insight about the threats in European markets, nor about which countries in Europe were relatively more likely to default. (Norway, which remains among the most solvent countries in the world, had a AAA rating in 2006, but so did Ireland and Spain.)

So with notably rare exceptions involving MBS and sovereign debt, S&P has done well with its ratings.

146

hartal 08.08.11 at 3:37 pm

But let’s look at the facts of this case. The world can see that the Republicans are willing to let the country default in order to prevent higher marginal rates and estate taxes or even the closing of tax loopholes. Clearly the Republicans have committed to a death fight over this on the grounds that it will put the US on a slippery slope to expropriate the wealthy.

I would be surprised if Japan had this level of political dysfunction. The threat of default means that the US will be tempted to monetize its debt; China has been saying loudly that it’s at the end of its rope with the US inflating away its debt and devaluing its dollar denominated assets.

So you have political dysfunction, coupled with anger from the world’s largest foreign shareholder in the American enterprise; how could that not result in a downgrade? Panic is not a solid basis on the basis of which to project US creditworthiness.

147

hartal 08.08.11 at 3:38 pm

Panic is not a solid basis on which to project US creditworthiness.

148

understudy 08.08.11 at 3:58 pm

Credit risk is based on the willingless and ability of the borrower to repay. Not very difficult, and, while not a political expert, I believe there is a strong political consensus in the US to not raise taxes OR cut spending. I can see that political dynamic continuing until China, Japan and Russia stop funding these deficits. At that point, yes, I believe the probability of default is a non-zero number. I know most liberals I speak with would chose social security payments to poor people over interest payments to billionaires.

149

mpowell 08.08.11 at 4:03 pm

Let me put it another way: for the same debt/GDP ratio, the same current year’s deficit, and the same political system, a country’s monetary system has an enormous impact on likelihood of default. And you see no actual appreciation of this basic economic fact with these ratings agencies. The Euro is really the worst possible circumstance. Italy, for example, has no control over monetary policy, no central bank which can purchase it’s sovereign debt and no way to devalue it’s currency. Italy would have no debt crisis (and their bond rates would be far lower) if they were still borrowing in lira.

Japan and the United States are in the opposite position. And conta Ed, I am not aware of any sovereign default in which the debt was denominated in a fiat sovereign currency. If all conditions are not met, guarantee does not apply. And this is why Argentina is not actually a counter-example.

150

Unsympathetic 08.08.11 at 4:07 pm

S&P in fact does NOT have a good track record with respect to sovereigns. The test for this isn’t something you heard asserted loudly on Faux News – rather, the test is looking at the countries currently rated AAA by S&P and examining the history of each of them. What’s this we see? Multiple european countries rated AAA who have defaulted on their sovereign bonds before? I’m shocked. Seriously, people, go read Reinhardt and Rogoff’s 08 paper discussing the historical reality of default risk by sovereigns.

Note, of course, that the actual market doesn’t give 2 rips about this downgrade. 10-yr at 2.4%. Bite my finger.

151

mpowell 08.08.11 at 4:09 pm


Credit risk is based on the willingless and ability of the borrower to repay. Not very difficult, and, while not a political expert, I believe there is a strong political consensus in the US to not raise taxes OR cut spending. I can see that political dynamic continuing until China, Japan and Russia stop funding these deficits. At that point, yes, I believe the probability of default is a non-zero number. I know most liberals I speak with would chose social security payments to poor people over interest payments to billionaires.

Again, this view reflects a misunderstanding of important macroeconomic facts. As long as China wants to buy US treasuries, their purchases have a deflationary impact on the US dollar which is bad for domestically generated growth and bad for a our trade deficit (ie, bad for external demand). Once China stops buying treasuries, it will be much easier for the US economy to grow and reduce our effective debt level even without legislative changes.

152

Ed 08.08.11 at 4:10 pm

Nate Silver is judging ratings against current market perceptions of default, not actual defaults. It’s strange that so many technically adept people have a hard time understanding how to check for probabilities.

Contrary to what dsquared claims (and what appears to be implicit in Silver’s analysis) the role of the rating agencies is not to be better than the market. What rating agencies have is a different view. And you can’t judge that by just looking at individual examples.

Krugman and dsquared mention that Japan was downgraded but interest rates remained low, and so claim that the rating agencies were wrong. Did you know that Greece was funded for years at AAA rates, even though the rating agencies rated Greece several notches lower? Did you know that back then the Greek government kept telling rating agencies they were wrong and should upgrade Greek debt? Well, according to Krugman’s and dsquared’s analysis the Greeks should have been upgraded.

This is the problem with trying to disprove probabilities by looking at individual examples. Look at Latvia during this last crisis and compare what the market said was the likelihood of default and what the rating agencies said. Turns out the markets were wrong.

Here’s the problem that dsquared and others seem to miss, that markets and market assessments of credit risk are very volatile and so have predicted 10 of the last 3 defaults. Look at Australia, which the rating agencies have kept at AAA during this whole crisis. Yet the current CDS spreads show it to be in the A category. So who is right?

And on Japan. Note how Krugman’s and others focus on bond yields, which are not direct measures of credit risk, yet don’t look at CDS spreads, which are meant to be. Why? Because if they did their whole argument collapses. Japan CDS spreads show an even greater downgrade than the rating agencies!

Markets have different views. CDS spreads put Thailand and Philippines as similar risks, but rating agencies tend to differentiate. The markets have Belgium today as junk! Not the rating agencies. Remember Nate Silver’s piece, which dsquared offers as great analysis, ends by saying that it’s better to follow market consensus. So that means that the rating agencies are too optimistic on Japan. Somehow I suspect Krugman’s will never mention this.

And I could go on. That’s why you need to look at the whole picture.

153

dsquared 08.08.11 at 4:20 pm

That’s why you need to look at the whole picture.

Which is what Nate did, in his regression analysis, isn’t it? And also what the works he cited did, isn’t it? And they didn’t reach this Slate-like contrarian view of yours that, with or without notable exceptions, credit rating agencies have got a really good track record. They’ve actually got, as I said above, a really good track record of being more or less useless lagging indicators in emerging markets, and a pretty bad track record in developed markets.

154

Ed 08.08.11 at 4:36 pm

Which is what Nate did, in his regression analysis

No, it isn’t. He checked the ratings against CDS spreads, not actual defaults. Rating agencies don’t seek to predict CDS spreads.

And if you are going to assume that CDS spreads are the best measure of credit risk then why bother checking anything? Just stop there and use the CDS spreads.

Of course, as I point out, CDS spreads have their own relative rankings which Krugman and others conveniently avoid to discuss. Among other things they are telling us that Australia is not a AAA, Japan should be rated much lower, Belgium is speculative grade and so on.
.

155

politicalfootball 08.08.11 at 4:39 pm

So Ed, you think the S&P’s view that Spain is less at risk for default than Japan is defensible*?

*I’m not asking if you think it’s right. Just asking if you think it’s defensible.

156

Ed 08.08.11 at 4:43 pm

My own personal view? I think Spain is more at risk. But I think it’s defensible if you believe that market yields will rise but not get out of control.

157

leederick 08.08.11 at 4:43 pm

“S.&P.’s bond ratings from five years ago would have told you almost nothing about the risk of a default today.”

But don’t S&P’s ratings use a 3-5 year time horizon? You wouldn’t expect ratings from 2006 to tell us anything about the risk of a default today. Spain and Ireland were given AAA ratings and have yet to default. If you bought a five year bond based on that rating you’d have got your money back, and AAA’s the maximum likelihood estimate in that case and you can’t fault S&P. Or am I missing something???

158

Watson Ladd 08.08.11 at 4:44 pm

Ed, as time goes on the CDS spread approaches the probability of default. I’m assuming we get some warning of default here, which S&P also assumes. So S&P and the CDS spreads should converge if they are both good estimates taking advantage of all the information. (Priors don’t matter). But they don’t. So either S&P has a prior that is different from the market (which is odd) or S&P isn’t updating correctly (which given the non-martingale property of their ratings is very likely).

159

Ed 08.08.11 at 4:47 pm

If you bought a five year bond based on that rating you’d have got your money back, and AAA’s the maximum likelihood estimate in that case and you can’t fault S&P. Or am I missing something???

No, you aren’t. Silver is the one who is confused because he seems to think that ratings predict CDS spreads.

160

politicalfootball 08.08.11 at 4:53 pm

But I think it’s defensible if you believe that market yields will rise but not get out of control.

Well, yes, if. But is it defensible in the real world? That is, would it be defensible for S&P to not factor in the possibility that market yields will get out of control?

Are you saying the S&P’s rating is defensible with notably rare exceptions?

161

Ed 08.08.11 at 4:58 pm

No, what i’m saying is that they are simply expressing an opinion. That’s all it is. If you look at the historical evidence their default predictions have done pretty well, but they are by no means perfect.

I also repeat that people like Krugman and dsquared that talk of how ratings simply lag market moves appear unaware of the very different credit rankings you get if you look at markets carefully. In some cases such rankings directly contradict what these analysts have been saying (krugman and Japan). That’s why you can’t simply pick and choose some individual cases.

162

dsquared 08.08.11 at 5:00 pm

Ed, your evidence that “ratings don’t just lag market moves” seems to consist of a list of cases where the market has moved, but the rating hasn’t been downgraded yet. That’s not very convincing.

163

Ed 08.08.11 at 6:01 pm

That’s not very convincing.

I know. When your mind is already made up nothing can convince you.

164

hartal 08.08.11 at 6:08 pm

165

hartal 08.08.11 at 6:40 pm

You do know that I think you’re all missing the story. S&P’s downgrade is an expression of Chinese power: it wants to limit the alacrity with which the US runs up debt only to inflate it away. It is threatening to diversify out of Treasuries or even retaliate in some way. Aware of mounting Chinese frustration, Obama, under the guidance of Robert Rubin, himself pushed for a $400 bn debt reduction plan and tried to use the debt ceiling deadline to push for it–he could have tied a rise in the debt ceiling to an extension of the Bush tax cuts. But he knew that he had to pressure both parties to accept a big debt reduction plan, and wanted to use the debt ceiling deadline to get a mix of revenue increases and spending cuts. He played a high risk game, and almost got burned to political death.

China is doing what it can to protect its not insignificant trillion dollar investment. This may prove to be a failed attempt at a transition to a post-hegemonic or multi-polar but the process has begun. I haven’t read Giovanni Arrighi yet, but he is probably more relevant in this context than S&P’s general credibility.

166

Lemuel Pitkin 08.08.11 at 6:53 pm

You do know that I think you’re all missing the story. S&P’s downgrade is an expression of Chinese power: it wants to limit the alacrity with which the US runs up debt only to inflate it away.

Sorry, but this makes no sense.

Austerity in the US is bad for China, and particularly bad for Chinese exporters. China derives various benefits from an export surplus with the US — climbing the technology ladder, supporting aggregate demand while holding down wages, insulating itself from financial pressures that face low-income net borrowers. That export surplus requires, as a matter of accounting, net borrowing by some sector in the US, either business, households or government. So while telling the US that our debt is the problem is a convenient (and not unreasonable) way of deflecting accusations of mercantilism, China has no genuine interest in an end to net borrowing by the US.

China is doing what it can to protect its not insignificant trillion dollar investment.

The idea that China’s leaders are more worried about avoiding paper losses on their reserves, than about growth and employment, is beyond silly.

I haven’t read Giovanni Arrighi yet

What have you read?

167

hartal 08.08.11 at 7:00 pm

I have read the very loud announcements coming from Chinese officials. Have you been ignoring them? They are clearly not on the same page as you are. They want a long-term debt reduction plan of the kind that Rubin has proposed (no short term cuts); that is what Obama tried to deliver. Of course China wants to continue to lend to the US but it does not want its debt inflated away. Chinese officials don’t think it’s silly to worry about several hundred billions of dollars “paper” losses .

168

hartal 08.08.11 at 7:05 pm

In other words, I don’t think the statements reported in the Bloomberg piece above are all bluff. You do. But on what basis? You think Chinese officials are talking that hot and heavy to deflect charges of mercantilism at a time when people are focused on other things. No, it seems that they want everyone to understand why the downgrade was justified, and long overdue.

169

Lemuel Pitkin 08.08.11 at 7:20 pm

I read it. Nothing there about fears of US inflation. Which isn’t surprising, since the Chinese government isn’t, you know, crazy.

The Chinese government is concerned about the Chinese economy. The tradeoff is between keeping the RMB low to boost export demand, and letting it rise to help control inflation. Capital gains and losses on reserves are completely irrelevant.

170

hartal 08.08.11 at 7:39 pm

Really nothing about fears of the monetization of the debt, devaluation of their dollar holdings? Nothing about losses on their reserves? Wow. Nothing you say!

171

john c. halasz 08.08.11 at 7:53 pm

hartal:

Chinese officialdom isn’t economically ignorant and they realized a long time ago that their $ reserve accumulations would eventually be subject to devaluation, with proportionate capital losses. Maybe they are being loud now for domestic consumption, eh?

172

Popeye 08.08.11 at 7:55 pm

Mostly they seem concerned that the US is spending too much on its military.

173

Lemuel Pitkin 08.08.11 at 7:58 pm

Losses due to dollar depreciation are not the same as inflation. And no, I did not see anything about debt monetization. Which, again, would be a remarkably silly thing to worry about when Treasury yields are at record lows.

Look, Chinese officials may not like holding US debtm but they definitely don’t want further dollar depreciation. To prevent it, they have to keep buying dollar assets. So they’re stuck.

And of course, if the downgrade had raised yields, that would have produced exactly the capital losses on reserves the Chinese government is supposed to be working so hard to avoid.

Right now, the Chinese central bank can stop buying US assets, which has the benefit of freeing up foreign exchange for other things than accumulating excess reserves, and the disadvantage of causing the RMB to appreciate against the dollar. Or they can keep buying US assets, holding the RMB down but keeping the reserve pile growing. Since they are free to stop buying Treasuries any time why want, the fact that they haven’t proves that they regard the costs of RMB appreciation to be higher than the costs of accumulating more reserves. If they change their mind, all they have to do is stop buying dollars.

Now suppose, instead of stopping their own purchases, they put pressure on the S&P to downgrade US debt, causing other people to stop purchasing dollars instead. Then they get the downside — RMB appreciation — without the benefit of ending the growth of reserves. It’s strictly inferior to just ending their own dollar purchases.

Your theory doesn’t work.

174

Beyonder 08.08.11 at 8:08 pm

While this is a very interesting discussion, I’m at a loss to understand why the main reaction to (and discussion prompted by) this most recent downgrade is to question (again) the role of the ratings agencies. There seems to me to be little question that a downgrade was the correct call, notwithstanding the math error. To be rated AAA, long term debt must be the safest in the world, with almost no risk of default. The US came within a hair’s breath of default just last week, as a result of a toxic political culture that shows no signs of dissappearing. Given that we are dealing with projections about long term debt obligations, with maturities as much as 30 years away, can anyone really still say that this is the safest debt in the world?

It seems obvious to me that you can’t, but if you disagree, surely this is a view that can be honestly held, and shouldn’t prompt this sort of knee-jerk backlash?

175

Lemuel Pitkin 08.08.11 at 9:54 pm

Beyonder-

(1) It’s not at all clear that the US ‘came within a hair’s breadth of default.” We don’t how the Treasury would have handled a failure to lift the debt ceiling. It’s very likely that they would have prioritized debt payments, in which case current revenues would have been more than sufficient to avoid default.

(2) S&P justified their decision on the basis of budget issues completely irrelevant to the political factors that might cause default. Reducing Medicare expenditures has nothing to with the toxic political environment.

(3) S&P has no special expertise in the political process. The financial factors that guide ratings for private borrowers are not relevant to the US or other developed sovereigns. This action seems to be a political move to encourage austerity policies favored by owners of financial assets. It adds no useful information and undermines whatever credibility S&P has within its core business.

176

Steve LaBonne 08.08.11 at 10:13 pm

It’s very likely that they would have prioritized debt payments, in which case current revenues would have been more than sufficient to avoid default.

It’s more than “very likely”. I clearly recall that being their publicly stated position. Every reference to “default” during that whole circus- and now- was/is either ignorant or dishonest.

For Beyonder- if this rating made sense one might wonder why neither the other ratings agencies nor actual bond investors seem to be following S&P’s lead.

177

Walt 08.08.11 at 10:42 pm

I actually thought that their stated position was that they would not prioritize payments.

178

Barry 08.08.11 at 10:45 pm

Piling on – first, S&P is a corrupt organization, which rated vast quantities of junk bonds as triple-A, in return for payments. Any conversation which doesn’t start with this is not connected to reality.

Second – see Krugman and Nate Silver for an analysis of the fact that their expertise on sovereign debt is negative.

Third – they produced bad math and when caught changed their reasoning. Obvious fraud. Krugman was pointing out what these sort of lies meant back when the Bush II administration was young.

Fourth – if the US defaults on it’s debt, there is no safe haven. That would mean a worldwide financial catastrophe, hitting every continent but Antarctica.

179

Beyonder 08.08.11 at 10:56 pm

Lemuel.

(1) whether it was a hair’s breath, or whether it was simply, as you put it, a case where “we don’t (know) how the treasury would handle” the failure to lift the debt ceiling, more than enough uncertainty was injected into the process to justify the downgrade. Very hard to say after that debacle that there was almost no chance of default on a US ten year bond.

(2) I agree that reducing medicare expenditures has nothing to do with the toxicity of the political process, but neither I, nor s&p, said that it did. Unaddressed spiraling medicare costs are, however, highly relevant to whether the US can meet its debt obligations, especially in the absence of tax increases.

(3) I’m not sure what sort of special expertise you propose they should cultivate to satisfy your requirement that analysts be “experts in the political process”. In any event, the CRAs do not use remotely the same rating process to rate sovereigns as they do private companies. The Analysts responsible for sovereign ratings do so exclusively. They routinely are required to assess political risk, and calculate its effect on creditworthiness. It falls within the core of their expertise.

180

William Timberman 08.08.11 at 11:25 pm

It falls within the core of their expertise.

Arrant nonsense. Defense of the prerogatives of an increasingly irresponsible plutocracy is the limit of any expertise a reasonable person would grant them — and even that would require discounting considerable evidence that an economy as thoroughly ravished as their sponsors desire ours to be is unlikely to remain stable no matter how total the victory they imagine themselves to have won.

181

Beyonder 08.08.11 at 11:26 pm

Steve.

Are you suggesting that because the downgrade isn’t reflected in the market price of the debt, the rating must be wrong? Seems a strange argument for this board. In any event, lots of ratings changes (downgrades and upgrades alike) have no effect on spreads.

Why haven’t other rating agencies changed their ratings? Stay tuned. S&P is the lead CRA, and while it is not uncommon for there to be small disagreements of a notch or two among ratings agencies, they tend to speak with the same voice.

Just to be clear, is it only S&P we say are crooked and worthless, or is it all of the Cra’s? Because if it’s all of them we can’t rely selectively on Moody’s and Fitch to justify our position when it suits us.

182

Ed 08.08.11 at 11:30 pm

Second – see Krugman and Nate Silver for an analysis of the fact that their expertise on sovereign debt is negative.

Don’t, actually. Turns out neither knows much about this topic.

183

Ed 08.08.11 at 11:33 pm

nor actual bond investors seem to be following S&P’s lead

The relevant market measure, CDS rates, shows that the market has agrees with the downgrade.

This is what happens when you trust people like Krugman, that lie or don’t know what the right market measures are.

184

Steve LaBonne 08.08.11 at 11:37 pm

Moody’s has already stated they will not follow suit. And yes, I am saying that yields would not be going down, and investors would not be fleeing from stocks into Treasuries if they really thought Treasuries were unsafe. What’s your argument to the contrary? What kind of investors bid up the prices of securities if they believe there really is new information that they’re more risky? That doesn’t prove S&P is wrong, but it shows that investors believe they are. Given S&P’s track record as discussed above, I would hesitate to take their word over the market’s.

185

Ed 08.08.11 at 11:39 pm

Steve,

You are looking at the wrong market numbers.

186

Steve LaBonne 08.08.11 at 11:44 pm

You are looking at the wrong market numbers.

Just as you need an argument for why Krugman is wrong, you need an argument for why Treasury yields are the wrong number to look at when somebody downrates Treasuries. Produce those arguments, not just assertions.

If you think stock prices are the right numbers, you also have to have an argument against the very plausible interpretation that investors are worried about slow growth aggravated by additional austerity measures. That might be connected to worries about the political response to the downrating but again does not establish that investors think the rating is correct.

187

Ed 08.08.11 at 11:51 pm

No, not stock prices.

Ratings are measures of credit risk. Bond yields are not. If Country A has a yield of 5% and Country B of 10% you can’t argue that the market thinks that Country B has more credit risk, since other factors, like inflation, could explain the difference.

But there is a market measure designed to estimate credit risk. It’s the CDS market, where investors buy protection against potential government defaults. You can calculate the implied rating from these CDS rates.

And the market has spoken and already downgraded the US. CDS rates for the US are now at the AA category level. This is something Krugman will conveniently forget to mention.

188

PaulB 08.08.11 at 11:56 pm

Certainly Standard and Poor’s were right to downgrade US debt. It is possible (not likely, but possible, check the bookies’ odds) that in a year and a half the US president will be someone who voted against the debt ceiling deal. If so, a default is very much a live possibility. The question rather should be why Moody’s and Fitch haven’t yet done the same as S&P.

However, if you want an unbiased assessment of the relative default risk of various bond holdings, you should ignore ratings and look at the CDS market. CDS spreads can be influenced by technical factors not directly related to default risk, but they are at least formed by people who care about not losing money much more than they care about politics.

189

Steve LaBonne 08.09.11 at 12:00 am

If Country A has a yield of 5% and Country B of 10% you can’t argue that the market thinks that Country B has more credit risk, since other factors, like inflation, could explain the difference.

We’re not talking about cross-country comparisons. We’re calking about the same country over a short time period. Why would anybody bid up the price of an asset if they believed there was genuine new negative information about its risk?

The rise in CDS rates on Treasuries was unimpressive (still well below the recent highs) and I don’t see any basis for claiming that it supports the soundness of S&P’s action.

190

Ed 08.09.11 at 12:01 am

However, if you want an unbiased assessment of the relative default risk of various bond holdings, you should ignore ratings and look at the CDS market. CDS spreads can be influenced by technical factors not directly related to default risk, but they are at least formed by people who care about not losing money much more than they care about politics.

But they are much more volatile than ratings and tend to overshoot a lot. Nothing is perfect.

191

Ed 08.09.11 at 12:03 am

The rise in CDS rates on Treasuries was unimpressive

Irrelevant.

What is relevant is that the correct market measure, CDS rates and not bond yields, show the market also agrees that the US is not AAA.

192

Steve LaBonne 08.09.11 at 12:05 am

What is relevant is that the correct market measure, CDS rates and not bond yields, show the market also agrees that the US is not AAA.

Interesting that you say this out of one side of your mouth after having just admitted the volatility and imperfection of the CDS market out of the other. But anything to promote your S&P-defending agenda.

193

Ed 08.09.11 at 12:10 am

No Steve.

I don’t defend anyone. I simply point out nonsense.

People like Krugman claim the market does not agree with S&P but that’s just because he is using the wrong market measure. The same happens with his Japan arguments, which dsquared has mentioned here. Once you look at the correct measure the whole argument falls apart.

194

BertCT 08.09.11 at 12:18 am

Watson Ladd – what makes this different is that S&P takes actions that affect the value of (all) other securities, and their information is actually required to be used by some statutes. S&P has a legal obligation to keep the mythical “Chinese wall” between it’s rating services and it’s investment advice – otherwise it is simply manipulating the market. In this case, it not only failed to do that, it even admitted that one reason it didn’t reexamine its rating of US credit was their clients had already gotten the information and, by inference, acted upon it. BEFORE the general public got the same info.

195

Ed 08.09.11 at 12:20 am

it even admitted that one reason it didn’t reexamine its rating of US credit was their clients had already gotten the information and, by inference, acted upon it. BEFORE the general public got the same info.

Did you just make this up?

196

Beyonder 08.09.11 at 12:23 am

Steve. I think I agree with everything you said there up to the last sentence. I don’t think investors have been spooked by the rating, although, as Ed is explaining, there are many other elements that go into the price of a bond besides default risk. This is why there are spreads between debts of the same rating.

I refuse, however, to accept the argument that this particular downgrade is wrong because of past mistakes made by the CRAs. Why? Because I actually read the downgrade document and I agree with it. It is seven pages long, written in the plainest English, and provides a number of clear justifications for the downgrade. So I don’t suggest that you take their word for it. I suggest you read the thing and then tell me why you disagree with it. Do you disagree with the commentary about the toxic politics? Do you disagree with their projections that the trajectory of the US debt burden looks different from other AAA countries? Do you disagree with their reliance on the revised historical GDP figures showing that the recession was deeper, and the recovery less robust, than originally assumed?

I would have thought any one of these factors could justify a single notch downgrade. Even if you are not persuaded yourself, you should be able to see the basis for holding that view without postulating crookedness on the part of S&P.

197

politicalfootball 08.09.11 at 12:46 am

Ed, with the CDS rate, you’re not measuring default here, but merely market perceptions of defaults. I have it on the highest authority (Ed in comment 152 and elsewhere) that this is inappropriate in this context.

Yes, I understand that S&P trails the CDS market in rendering opinions on potential defaults – but that’s my point, not yours. Until now.

Certainly, I’m not arguing that AA is an inappropriate rating for U.S. debt – just that S&P adds almost no information that wasn’t already in the market.

198

Ed 08.09.11 at 12:51 am

Certainly, I’m not arguing that AA is an inappropriate rating for U.S. debt – just that S&P adds almost no information that wasn’t already in the market.

Fine.

And since you rely on CDS spreads that means that you know that Krugman is misrepresenting what happened in Japan.

Do you also think Australia is in the A category, as the CDS market implies, or do you think it is AAA, as the rating agencies say?

199

understudy 08.09.11 at 1:16 am

“Certainly, I’m not arguing that AA is an inappropriate rating for U.S. debt – just that S&P adds almost no information that wasn’t already in the market.”

That seems too high a burden – short of breaking into the Treasury, CIA or Fort Knox, what material non-public information could you expect them to have? Their value is their analysis and conclusion – you can attack that, but saying they didn’t turn over something completely new to the market is too much.

“Yes, I understand that S&P trails the CDS market in rendering opinions on potential defaults – but that’s my point, not yours. “

But isn’t that Ed’s point with Australia – how do you know that S&P is “trailing” the CDS, unless you have already determined they will face a down fiscal scenario? Australia still has among the fastest growth, lowest unemployment, lowest fiscal deficit, overall debt to GDP, good population growth and immigration … May be S&P is the voice of reason in a market full of emotion?

200

hartal 08.09.11 at 1:25 am

Who is this guy? Who gives him the right to go off like that?

http://www.cnbc.com/id/44050325

It may be silly for them to worry about debt monetization, LP, but there you have it. And he beat S&P to the punch; that’s probably where S&P got the confidence to talk smack to the strongest state in the world.

201

john c. halasz 08.09.11 at 2:10 am

@200:

You might be right that Obama is towing the line for Rubinomic deficit/debt superstitions, and certainly the Chinese would have a long-run interest in a different FX system than the “BW2″ /US$ as sole reserve currency one. But public pronouncements by Chinese officials or their acolytes doesn’t amount to reliable evidence. The real “action” occurs behind the scene.

202

politicalfootball 08.09.11 at 2:12 am

And since you rely on CDS spreads that means that you know that Krugman is misrepresenting what happened in Japan.

I don’t rely on CDS spreads. I do think they’re a more useful indicator of potential default than S&P ratings, but I don’t rely on them to be correct or anything.

As for Krugman, he says S&P downgraded Japan. I think you agree there.

Krugman, further, says that the downgrade didn’t add any meaningful information about Japan’s ability to repay its debt, and that Japan has had no trouble borrowing since then. Is there some part of this you disagree with? If so, which part and why?

Krugman is so great because he makes a habit of being right all the time – not just about the past, but about the future, and about controversial issues. When he brought up Japan, he did so in order to argue that information about U.S. debt was already in the market, and the ratings agencies weren’t going to add to that information. He argued that the U.S. would continue to be able to borrow at favorable rates. A lot of folks thought otherwise. What’s your contrary case? What is it about Krugman’s statements that you disagree with?

203

politicalfootball 08.09.11 at 2:19 am

Their value is their analysis and conclusion – you can attack that, but saying they didn’t turn over something completely new to the market is too much.

We agree. I don’t expect S&P to uncover inside information. All of the value of their work is in their analysis and conclusions. Every bit of it. I’m just unable to see what the value is.

But isn’t that Ed’s point with Australia – how do you know that S&P is “trailing” the CDS, unless you have already determined they will face a down fiscal scenario?

Ed explained this at some length above. I don’t claim that the market has a better read on Australia or anyplace else. My claim is that the market generally has a better read on these things.

204

Ed 08.09.11 at 2:33 am

Krugman, further, says that the downgrade didn’t add any meaningful information about Japan’s ability to repay its debt, and that Japan has had no trouble borrowing since then. Is there some part of this you disagree with? If so, which part and why?

If that’s all Krugman had said there would be no debate. But there was more. He claimed that Japan is a case where the rating agencies downgraded but the markets did not worry. Unfortunately that’s only true when you misuse market measures. Using the correct market measures the markets did worry. In fact, they worry more than the rating agencies, since Japan’s implied CDS spreads are in the A category.

205

Ed 08.09.11 at 2:38 am

My claim is that the market generally has a better read on these things.

To be clear, I don’t necessarily disagree. My only point is that if you are going to judge market measures vs ratings, you can’t simply cherry pick. You need to look at the whole enchilada. And the results become much less clear once you do that. Do you think Belgium’s default risk is higher than Guatemala’s? That’s what CDS spreads are showing.

206

Ed 08.09.11 at 2:42 am

What is it about Krugman’s statements that you disagree with?

Strangely I always agreed almost 100% with what he wrote. But most of what he wrote was on areas I had no special expertise, for example the liquidity trap, so I had to trust what he was writing. But when he started writing about things I do know, such sovereign credit risk and rating agencies, I began to realize he did not know what he was talking about or was being purposefully deceitful. That’s beginning to make me question the rest of what he has written. It’s also making me rethink what a lot of other academics attacking Krugman have said.

207

F 08.09.11 at 3:22 am

“The CDS market disagrees, pushing France’s five-year CDS spread out to nearly 160 basis points, Citi analysts note, almost three times as wide as US CDS spreads. The market thinks the US is more AAA than France.” – WSJ

208

John Quiggin 08.09.11 at 3:38 am

I’m pretty sure Krugman has made the same point as F@207 on CDS spreads – certainly I’ve seen it and not in the WSJ. Also, Nate Silver in 538 has done a pretty thorough demolition of S&P, concluding they add negative information to what is in CDS spreads.

209

Ed 08.09.11 at 3:50 am

John,

I’m afraid Krugman hasn’t. Krugman picks and chooses the data that supports his views but ignores that which doesn’t. That’s why he uses bond yields in his examples about Japan because if he used CDS spreads his whole argument collapses.

I’m also afraid Nate SIlver did not do a very good job. You see, he tested S&P’s ratings against CDS spreads. It seems he is unaware that rating agencies don’t try to predict CDS spreads, just defaults. Of course, he could have tried to do a real default study but that requires a lot more work, and he couldn’t have done that in time to get a good link-bait article for his blog.

It’s funny how these memes spread. Now you and others will continue to repeat that Nate Silver demolished S&P even though a quick look shows Nate Silver does not even understand what rating agencies measure.

John, take a look at the CDS spreads which you and others claim are so superior to ratings, so that ratings add no value. Right now Australia is in the A category according to the CDS rates, but AAA by the rating agencies. Who do you think is right? As for France, the CDS spreads are indicating that there is little difference between France and Guatemala on credit risk. Do you agree with that, or do you agree with the rating agencies, that think that France is a much better credit?

210

Watson Ladd 08.09.11 at 3:58 am

Ed, why don’t you buy some Guatemalan CDS contracts and sell a few French ones to profit off your perception of inefficiency? We’ll see how much money someone following S&P ratings makes.

211

Ed 08.09.11 at 4:02 am

So Watson, you think France is a worse credit risk than Guatemala?

212

hartal 08.09.11 at 4:39 am

Rogoff joins China-S&P axis, calling the downgrade generous in part because of valid concerns about the diminishing “quality” of the payments that the US will making on its debt. Chinese officials wanted to punish the US for (and deter future) excessive quantitative easing even if it meant a substantial immediate hit on their own assets. This will really box Bernacke in as it doubtless was meant to.

If the Tea Party had agreed to the Obama/Rubin/Chinese $4 trillion dollar debt reduction package–interesting that the President did not once mention China in today’s address–Bernacke would have had more wiggle room. But the Tea Party stole his tools.

President Obama gave into financial terrorism. The voters did not have his back. The pseudo-lefts abandoned electoral politics, leaving the same population that put Bush back into power after the horrors of Abu Ghraib to vote Teabaggers and birthers into office.

The country is very close to coming apart at the seams.

213

Consumatopia 08.09.11 at 4:59 am

It seems he is unaware that rating agencies don’t try to predict CDS spreads, just defaults.

You didn’t actually read what Nate Silver wrote:

One might reasonably protest that my study (although not Ms. Reinhart’s) is comparing apples to oranges. Whereas S.&P. is attempting to forecast actual defaults, I’m instead looking at the market’s perceived risk of default as of today. None of these countries have actually defaulted yet. There’s still the chance that the markets turn out to be wrong and S.&P. turns out to be right.

Here’s the problem with that: S.&P. ratings tend to lag, rather than lead, the market. That is, in cases where the market’s view of default risk is misaligned with S.&P.’s, S.&P. is a good bet to change their rating to catch up to market perception.

Most of the rest of the piece goes on to expand on that point.

214

john c. halasz 08.09.11 at 5:07 am

@212:

Who are the “pseudo-lefts (who) abandoned electoral politics”? The broad mass of his “base” or potential base who realized that he had betrayed any promises he’d made them and had nothing left to offer? You’re indulging in twisted “logic” there.

(Oh, and Rogoff is well worth listening to carefully, since he’s very smart, but also, if you follow carefully, a right-wing snake.)

215

Ed 08.09.11 at 5:07 am

I did read it. Nate Silver simply created his own definition and thus the whole study is useless.

Rating agencies don’t try to predict CDS spreads, so Silver’s analysis is wrong.

And if he is going to claim rating agencies lag the market he needs to provide detailed proof, and explain all the examples. For example Latvia. Or Mexico. Or Australia. I could go on.

216

Ed 08.09.11 at 5:13 am

Some more on how bad Silver’s analysis is. He writes :

By comparison, simply looking at a country’s ratio of net debt to G.D.P. would have been a better predictor of default. It wouldn’t have done well by any means: it only explains about 12 percent of default risk.

Did you catch the error? He is confusing CDS rates with actual defaults! And this buffoon wants to criticize S&P?

217

Ed 08.09.11 at 5:22 am

More on the useless Silver study. He claims to have found evidence that S&P seeks to minimize rating changes. What a genius! This is part of the dual mandate rating agencies have, and which Silver seems not to understand. Rating agencies know they will be slower to react because that’s part of their explicit mandate. That’s why ratings are much less volatile than CDS spreads. In fact, it’s explained in the IMF review of sovereign ratings.

This is yet another example of someone opining about something they only half understand.

218

F 08.09.11 at 5:42 am

Ed

@183 You claim that the relevant metric is the CDS spread, then when we point out that CDS spreads are actually quite low for the US, you claim that CDS spreads are irrelevant in @209. Move the goalposts much? So what exactly is your argument?

219

Ed 08.09.11 at 5:53 am

F,

I claim two things:

1. That if you want to look at market perception of default risk you need to look at CDS spreads, since that’s what they are designed to do. You can’t do as Krugman does and use bond yields just because it fits your line of argument.

2. But just because CDS spreads are the market measure of credit risk does not mean they are perfect. So if you do use them or consider they are better than ratings, you need to understand their limitations. One key limitation is that they are much more volatile than ratings, and this is by design. That’s why so many regulators and investment funds prefer to use ratings instead of CDS spreads to determine cutoff points. Because if they used CDS spreads they would have to make huge changes to their portfolios all the time.

Points 1. and 2. are not contradictory. They simply address different issues.

220

F 08.09.11 at 5:55 am

Or to put another way, if CDS spreads and Treasury yields are both predicting low risks of default, what’s your contrary evidence?

221

Ed 08.09.11 at 6:01 am

None, at least from the market. You could have a contrarian view if you thought the market measures were wrong though.

222

F 08.09.11 at 6:09 am

So, then, why did you make a big deal out of CDS spreads as supporting your point? Your goalposts have been shifting constantly.

223

F 08.09.11 at 6:12 am

IOW, your point is all the things that I cited in favor of my point don’t actually favor my point, and in order to believe it, you must be a contrarian.

224

John Quiggin 08.09.11 at 6:40 am

@209

That doesn’t seem right. Australian CDS spreads were below the US and Germany a couple of weeks ago
http://www.bloomberg.com/news/2011-07-28/australia-default-swaps-below-u-s-germany.html
though they are now back above, I think. I don’t think 20-odd basis points relative to the AAA benchmark (say Germany) can be consistent with an A rating.

I certainly don’t want to suggest that the CDS markets are perfectly efficient. The question is whether, in aggregate, ratings agencies add value. As you’ve argued above, that can’t be resolved by picking individual cases.

225

Andrew F. 08.09.11 at 11:08 am

Ed, the problem with looking at the CDS spread for US debt is that the market is quite small.

Moreover, the spread itself doesn’t make your point. Compare the US to Austria, France, Germany, and other AAA rated sovereigns.

As to yields, you’re certainly correct that there are factors other than credit risk which play a role, but if you assume that those other factors, such as inflation risk, haven’t changed much in the last several months, then it becomes difficult to explain why the low yield is not indicative of stability in credit risk as well.

226

CanaryattheWharf 08.09.11 at 11:11 am

A bit late and haven’t had time to run through all the comments so apologies if this has been said.

Ed is correct that a country that issues debt in its own currency can still default but the process is drawn out. It operates especially well where the country runs persistent current account deficits and has to borrow from external creditors. (i.e. the US or UK now)

Whether from debt issuance or outright printing money (Quantitative Easing) the borrower’s currency depreciates against other countries, with a loss of value to external debtors and usually higher inflation rates that affect domestic purchasers of bonds. Neither of these are default risks but they do over time reduce the return to investors and hence their willingness to lend to these governments.

At some point lenders can either refuse to buy additional new debt or at least require higher interest rates to compensate for these risks (Italy any time prior to the adoption of the Euro). Foreign lenders can also choose to require the country’s bonds to be issued not in its domestic currency but theirs instead – at which point the borrowing country loses the protection of being able to print its way out of funding gaps.

Even where creditors simply demand higher interest rates to compensate for inflation risk this can create a spiral where the burden of interest payments simply rises so fast that the choice is hyper-inflation or default – with some, like Russia in 1998 taking the latter course.

Now this still seems (and is) an absurd scenario for the US NOW – but is it in the long-term? The risk of the US losing its reserve currency status some years from now is not nil and is probably rising as China etc. lose patience with the US. Under these conditions, its fiscal weakness and the political polarisation commented on by S&P, the chance of the spiral noted above being set off has risen – hence the downgrade. (though the risk is still very low just not extremely low.

Sorry for the long-winded “explanation” and the nickname – I work in this field, though not for an agency. They did get it horribly wrong over ABS/CDOs – a modelling and greed problem – but the corporate and sovereign methodology & track record are both pretty good.

Also, while S&P have been criticised for saying the package was insufficient, what’s being missed is that their main objection (and a key reason for the downgrade) is they think the Tea Party has made it impossible to terminate the Bush tax cuts or raise other taxes – they probably agree with most here that endless austerity has its own risks a la Greece

227

Consumatopia 08.09.11 at 11:40 am

Rating agencies don’t try to predict CDS spreads, so Silver’s analysis is wrong.

So not only didn’t you read Nate Silver, you didn’t even read the part I quoted. Silver’s argument is not that S&P is failing to predict CDS spreads, but that S&P’s ratings lag behind CDS rates and thus fail to add value as a predictor of defaults.

228

PaulB 08.09.11 at 12:25 pm

Nate Silver’s analysis of credit ratings is not nearly as good as his psephology:

- he is careless about the meaning of CDS spreads, at one point going as far as to say “simply looking at a country’s ratio of net debt to G.D.P. would have been a better predictor of default” when what he actually means is that it would have been a better predictor of future CDS spreads. I think he knows, at least roughly, what CDS spreads actually are, but he seems to be more interested in using them for polemics than for analysis.

- it’s not difficult to find an indicator that would have worked well once you know the outcome. I dare say I could use a similar approach to discredit psephologists. If I wanted to use dishonest methods to do so.

- he makes great play with the fact that credit ratings lag the CDS market. But this is by design. Suppose one wanted to create a list of approved investments of the sort John Quiggin proposes, but without relying on the skill and independence of regulators. One might start with CDS spreads, then to avoid bonds moving on and off the list too often one would apply some sort of averaging, perhaps an exponentially-weighted moving average with a half-life of a few months. Then one could could establish various quality bands according to the premium in average CDS spread of a each bond over the best quality sovereign issue. This sort of rating (which I recommend) would inevitably lag the CDS market, and at a time when spreads had progressively widened would look rather leaden-footed. However, at a time when spreads had jumped up then recovered, it would seem to be exercising sober and considered judgment.

I agree with Nate Silver that the ratings agencies have shown no obvious insight into sovereign default risk. More generally, unforeseen financial crises occur frequently enough to make any sort of medium-term economic forecasting hopelessly inaccurate. But none of this means that S&P was wrong to downgrade the USA.

229

Ed 08.09.11 at 1:58 pm

F @222-223 Apologies if I am not clear. I thought I tried to explain how I see CDS as the correct market measure of credit risk but how it also has important limitations. I guess I wasn’t succesful.

John @224 I use a market report that translates CDS spreads into implied ratings.

Andrew @225 True, CDS spreads have their issues. But so do bond yields. There are technical reasons that support low yields for the US, which are good for the US funding but don’t really reflect comparative credi risk views, which the CDS market does seek to measure.

Consumatopia @226. Silver makes several mistakes which make his analysis useless to understand ratings (but probably very successful as blog bait). Not only does he confuse CDS spreads with actual defaults (I quote him on that) but he is unaware of rating agencies’ dual mandate, which includes ratings stability. This second mandate, explained in part in the IMF report on sovereign ratings, is something the CDS market does not have and explains why rating agencies will generally lag the market when a country finally downgrades but also explains why they overshoot much less, which is very valuable to many market participants. I gave the example of Latvia but there are others. If you want to measure what information rating agencies provide that the market does not you need to look at all the many market “false positives”. That’s why I gave all the examples I did, such as France and Guatemala.

230

Consumatopia 08.09.11 at 2:40 pm

Ed, you seem to be completely incapable of reading my posts. Try 213 again. You said “It seems he is unaware that rating agencies don’t try to predict CDS spreads, just defaults. ” Silver said “Whereas S.&P. is attempting to forecast actual defaults, I’m instead looking at the market’s perceived risk of default as of today.”

I’m not arguing any larger point about S&P or Nate Silver, just pointing out your illiteracy.

231

Walt 08.09.11 at 2:55 pm

So despite Ed’s attempts to fool us otherwise, it seems pretty clear that the ratings agencies have a surprisingly poor track record of evaluating default risk. Since sovereign debt has got to be the easiest to evaluate, you have to wonder why the ratings agencies persist in an activity that they seem so poorly suited for. This was particularly obvious for S&P after their bizarre arithmetic error. I always assumed that it served as an advertising function, but after the bad publicity it must be essentially a service that they provide for their most valued customers, like the big investment banks. One goal seems to be to influence public policy. David Dayen mentions a case where S&P used their ratings business to help eliminate government regulation that was inconvenient for Wall Street.

232

michael e sullivan 08.09.11 at 2:58 pm

We ought to be a bit careful about suggesting that debt/GDP ratio is completely irrelevant for sovereign debt. At levels that ordinarily strike us as high, but are not completely pathological (i.e. the current debt level of the US or Japan or even what they might become in a few years should either country embark on a very aggressive fiscal stimulus, for instance) then you are correct, default risk is almost completely uncorrelated with debt/GDP ratio and is all about politics.

On the other hand, there are debt levels that could force a sovereign currency issuer to choose between hyperinflation and default. Since hyperinflation is likely to be just as bad for debt holders as default, it’s not completely crazy to be concerned about. But you’d need much higher debt levels, budgets much further from primary balance, or currencies with major market confidence problems for that to become a real issue. None of these are issues with debt issued by the US or Japan, so it seems reasonable that investors have the correct take here, which would be that US and Japanese government obligations are among the safest investments in the world right now, whatever S&P thinks.

233

understudy 08.09.11 at 3:15 pm

“Since sovereign debt has got to be the easiest to evaluate, you have to wonder why the ratings agencies persist in an activity that they seem so poorly suited for.”

Oh really? Sounds like we need you to work at the ECB – perhaps your ease of evaluating sovereign debt would have helped save the Euro from near collapse because of the sovereign default of one of its (lowest rated) members. I don’t believe Greece will escape without a debt “restructuring”, whether the ECB calls it a default or not.

234

Walt 08.09.11 at 3:19 pm

What?

235

Ed 08.09.11 at 3:24 pm

I’m not arguing any larger point about S&P or Nate Silver,

In that case then why are you arguing at all? Nate Silver made a mistake that makes his study useless. It doesn’t matter that he acknowledges the mistake, it’s still an error. if I say “I know an oven is supposed to be used to bake things, but i’m going to measure how well it does as a swimming coach” that is still a meaningless exercise.

Ratings are meant to predict defaults, which they do pretty well. In fact, Silver links to a study by Reinhart that says just that, but glosses over it. Ratings are not meant to predict CDS spreads, so any econometric exercise that does that is simply useless. Well, not completely useless. It helps him raise the hit count in his blog.

236

Ed 08.09.11 at 3:26 pm

Understudy,

Yes, Walt is another one of those geniuses in theory, he just knows that something he has never done is really very easy!

237

Consumatopia 08.09.11 at 4:24 pm

In that case then why are you arguing at all?

You said something that was simply false, I pointed it out. If you can’t see your simplest mistake, there’s no point in me trying to correct any of your slightly more complicated misreadings, as others have repeatedly tried to. Nate Silver’s analysis does not assume that ratings are meant to predict CDS spreads.

238

Ed 08.09.11 at 4:28 pm

Consumatopia : Nate Silver’s analysis does not assume that ratings are meant to predict CDS spreads.

Nate Silver : By comparison, simply looking at a country’s ratio of net debt to G.D.P. would have been a better predictor of default. It wouldn’t have done well by any means: it only explains about 12 percent of default risk.

Do I need to explain this again?

239

politicalfootball 08.09.11 at 4:48 pm

Ed, if you’re going to argue that Silver erred in his use of swaps, you actually have to engage his argument. You’ve repeatedly said that swaps aren’t the same thing as defaults, but Silver himself says this, and explains his choice. If you’re going to talk about this, you have to engage that explanation.

Further, you say that Silver erred in saying that ratings follow the market because it is part of the S&P’s mandate to follow the market. That looks to me like you are saying Silver is exactly right, but trivial. I disagree that this is a trivial point, but I probably come to this discussion with a different background and different set of interests.

Krugman is an interesting case. Fetching his most recent discussion of S&P and Japan, he (tentatively) argues that S&P ratings are useless for two reasons: They’re sometimes wrong; and they add no information to the market. He puts the Japan case in the “wrong” category, whereas you make a plausible case that they are in the “following the market” category. Either way, he understands the irrelevance of S&P information to the actual bonds being rated, and using that irrelevance, he was able to correctly call the bond market’s response to Treasuries after the U.S. downgrade. That’s still helpful, though I’d like to see him confront your argument to see if you and I are missing something.

240

Walt 08.09.11 at 4:49 pm

No one likes finding out they’re bad at their job, Ed. Sorry to be the bearer of sad tidings.

241

Consumatopia 08.09.11 at 4:53 pm

As PaulB said, Silver said one thing when he meant another. You could tell that he meant another thing if you had actually read the rest of the post (which you either will not or cannot), or even just the portion I quoted @213 (ditto). He’s comparing two different predictors of defaults, not assuming that one predictor is intended to predict the other.

You need to do more understanding, not more explaining.

242

understudy 08.09.11 at 5:04 pm

Walt -

S&P did a better job rating Greece than the markets or the ECB. Perhaps since you believe it is so easy and S&P does it poorly, your services would be better served working for the ECB.

243

Ed 08.09.11 at 5:21 pm

PF,

There are two related but separate issues. First, do sovereign ratings do their job, which is to rank order credit risk. Studies that look at this, both published by rating agencies and by academics like Reinhart, show that yes, they do. So when Nate Silver uses a regression to see if ratings predict CDS spreads he is doing nonsense, since that is not what ratings do and the results tell us nothing about how good the ratings are. It allows him to publish serious looking regression outputs but they are meaningless.

The second issue is, even if ratings do correctly rank order credit risk, is there an alternative mechanism that does the same but faster, ie do ratings simply repeat with a lag what the market says. This is something Nate Silver tries to address. (Note that his regression trying to see if ratings predict CDS spreads is of no use to answer this question). This is actually a very interesting question and one that, if answered appropriately, could support the idea that rating agencies provide little information. But it has to be done right, and Nate Silver does not do that.

Rating agencies have a dual mandate, not only to rank order credit risk, but also to have reduced volatility. For both investors and regulators there is a lot of value in avoiding ’false positives’ even, in some cases, at the risk of having some ‘false negatives’. This is something Silver is unaware of, although it doesn’t stop him from offering an opinion.

Let me try to elaborate on this with an example. Suppose you are a regulator that wants to make sure certain funds are not invested in risky assets and decide to use some sort of credit trigger (same logic applies to a portfolio manager). You have two options, ratings or CDS spreads. CDS spreads are much more volatile than ratings, and so the ‘trigger’ is hit much more often, with plenty of false alarms. Note that this is perfectly consistent with CDS spreads correctly predicting defaults. Yet it still creates problems because of all the times the markets signal worsening credit problems only to change their mind after a while. This is what happened to Latvia last year. It is, I’d argue, what is happening to Australia today, which the markets have ‘downgraded’. There are plenty of other examples, and also examples of false positives going up the rating scale.

This is, in fact, one of the main values of ratings. It is, I suspect, why so many studies show sovereign ratings can impact rates, even when the market had all the information. Since market measures tend to overshoot there is a ‘cry wolf’ aspect to this, and so maybe when a rating agency acts it has a different impact. At least it is something to be studied.

Silver does none of this. He does do a one time prediction of ratings based on CDS spreads, and this is the kind of analysis that if fully carried out could be useful. But it does not support the title of his blog and requires a lot of hard work, so he avoids that.

As for Krugman, note that while he was correct that there would be no impact on Treasuries after the downgrade that’s contradicted by the many many times ratings have led to yield changes in other countries, including other countries that are also very well studied. A honest analyst would ask himself why the difference (I have some theories) but Krugman chose the easy way out.

244

Frank Ashe 08.10.11 at 10:58 am

Hi,
Just throwing a spanner into the discussion on CDS; CDS spreads have at least two intertwined components: a probability of default, and a price for the bearing of the additional risk of that default. It’s almost impossible to tease out how much of the actual spread is made up of the two components. One explanation for the volatility of CDS spreads is that the price of risk for the marginal investor is very volatile (animal spirits?).

A credit rating should have no component of the price of risk but on at least one reading of S&P’s rationale they discuss something that sounds like the price of risk.

245

Andrew F. 08.10.11 at 11:21 am

Ed @229: True, CDS spreads have their issues. But so do bond yields. There are technical reasons that support low yields for the US, which are good for the US funding but don’t really reflect comparative credi risk views, which the CDS market does seek to measure.

The problem with using CDS spreads on the US in particular, though, is that the small size of the market means that you have a number of problems deducing comparative risk information from the spread. This is a problem in addition to other issues with deducing comparative credit risk from spreads generally.

And again, even if we did, the spread on the US is quite low. I can’t think of any market indicator, in fact, showing agreement with S&P.

I don’t have a problem with the ratings agencies generally, but I do think S&P may have overreacted to the debt ceiling negotiations. I say this without having looked at their model; my opinion is based purely on their press release. However, they’ve also been warning of this for months, and they were the most aggressive of the big three in their language, so there’s also a strong argument that the trigger was more quantitative (in the form of insufficient deficit reduction plans) than qualitative.

246

Ed 08.10.11 at 3:59 pm

Andrew,

But in that case S&P becomes even more relevant. There are, as I see it, three options in terms of measuring country credit risk:

1. Do nothing and deal with the consequences later. I haven’t heard anyone hear propose that, but I guess some could.

2. Rely on the rating agencies. By this I don’t just mean the current ones but any future ones as well, including any government run ones.

3. Market measures, which you say are not useful.

Given this it seems S&P’s importance is, if anything, growing.

247

Andrew F. 08.11.11 at 1:37 am

Ed, I didn’t say that CDS spreads are never useful. I said that they’re less useful in the case of the US, because the market for them is quite small. If you have a much larger market with greater liquidity, then CDS spreads become more useful. Yields are also useful, though of course like all kinds of market indications they are subject to many influences.

As to the ratings agencies, I do consider them useful. But that doesn’t mean there any indicators that show the markets agreeing with S&P. Far from it.

Nor would I judge a ratings agency based on whether it gets right the distinction between AAA and AA+ with respect to a single issuer. That said, there’s something stubborn and stupid about downgrading an issuer as uniquely situated as the US, based on qualitative factors, from AAA to AA+, when so few agree with your assessment.

I’ll rate S&P Aa3 for balls and Baa2 for brains.

248

Ed 08.11.11 at 2:23 am

Andrew,

The CDS market may not be perfect but it is what we have to gauge market perceptions of credit risk. I have seen no evidence anywhere that CDS spreads somehow are useful for most countries but not for the US. The US CDS market may not be large but it is not zero either. Market participants pay real money for those CDS contracts and they do so for a reason. And that market agrees with S&P. In fact that market downgraded the US even before S&P did.

I have a problem with inconsistencies. People in this thread (not you) quote approvingly of Silver’s analysis but then appear not to realize that he uses CDS spreads as a measure of risk, and that measure has already downgraded the US. You can’t simply pick and choose the risk measure depending on how it fits with your argument. That’s what Krugman did.

By the way, if you get sell side research I’m sure you know that there are plenty of people who agree with S&P, including Citi’s Buiter, one of the best analysts in my opinion.

249

Popeye 08.11.11 at 12:54 pm

I have a problem with inconsistencies.

Is that why you spend half your comments talking about how the market agrees with S&P, and the other half talking about how it doesn’t matter if the market agrees with S&P or not? You don’t sound like a lover of consistency, you sound like a rating agency apologist.

250

Andrew F. 08.11.11 at 2:26 pm

Ed, the small size of the US CDS market (about 5 billion notional – relative to over 9.6 trillion of treasuries) and the lack of liquidity means that the spreads are subject to influence by purchases and sales by single participants. So the size of movements in the spread aren’t necessarily indicative of broader sentiment.

Can you speak more as to what you think the implied probability of default is currently – not during the week before the debt ceiling deal – for the US in comparison to AAA countries such as France, Germany, or Austria?

I’ll check out Buiter, thanks for the reference.

251

hartal 08.12.11 at 4:38 pm

Comments on this entry are closed.