Saturday, August 6, 2011

U.S Credit Rating Downgrade - A Humpty Dumpty Moment


The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. We have coined this term to describe the current monetary and fiscal policies of the U.S. government, which involve unprecedented money printing. This is the official blog of the New York Investing meetup.

As everyone knows by now, S&P downgraded the U.S. sovereign debt rating from AAA to AA+ on Friday. While the extent of the downgrade is minor, the implications are major. As the recent debt ceiling negotiations revealed, the U.S. cannot run its day-to-day operations without borrowing money. It lives on credit (as do most countries in the world today) and anything that impacts its ability to borrow money has serious consequences.

It takes a lot for a credit rating agency to lower the credit rating of a top corporation or country. This is usually only done long after the actual credit worthiness has experienced a significant decline.  The last major Friday afternoon credit downgrade from the credit rating agencies was when they lowered Bear Stearns rating on March 14, 2008. The company didn't open its doors again the following Monday.  The rating agencies were also tardy with lowering the credit ratings of accounting fraud poster child Enron, although they all did finally lower its rating to junk status four days before it declared bankruptcy. Perhaps the best analogy to the current U.S. situation though is the AAA ratings given to a number of securitized bonds that held subprime mortgages. These turned out not to be worthy of a top credit rating after all.

The farcical nature of how the credit agencies determine the rating of U.S. government debt was made clear during the debt ceiling negotiations. Numerous articles in the press reported that failure to come to an agreement, which would allow the U.S. to continue to spend money it didn't have because it could borrow more, would be viewed as fiscally irresponsible! A more rational response would have been, it's quite obvious that the U.S. can't function without borrowing an increasing amount of money and it is therefore insolvent. Under such circumstances its credit rating should be at the junk level - a BB or less - not an AA+. Eventually, this might happen, but as was the case with Enron, this would mean the U.S. would likely be going under a few days later.

The difference between the AA+ credit rating and the BB or lower one is caused by the fantasy factor. The AA+ rating is based on the glorious financial past of the U.S. and ignores the current downward trajectory it is on. Before the debt ceiling problems temporarily curtailed spending for a while, the U.S. was on course for as much as a $1.65 trillion budget deficit. This represents 11% of the current GDP number of $15 trillion (there are many reasons to think GDP is substantially overstated). It is true, that the U.S. is not borrowing money to pay for most of this deficit however - it's printing it. Quantitative Easing 2, a form of money printing, conducted by the Fed covered 70% of the deficit in the first half of the year. A country doing this certainly does not deserve an AAA credit rating, nor does it deserve an AA+ credit rating unless you can make a case that a company engaged in the business of counterfeiting money also deserves a close to top credit rating.

The Obama administration complained that S&P overestimated future U.S. deficits by $2 trillion. What this means is that S&P refused to accept the pie-in-the sky budgets numbers that the government generates. If you look at these, you will see that they assume GDP growth of over 5% a year, each and every year, until 2016. One year of GDP growth over 5% would be good and continual annual GDP growth of over 5% for the U.S. economy just isn't possible. The budget scenario also assumes very low inflation, which would certainly not be the case if the high growth it assumes takes place.  A combined deficit of $20 trillion in the next decade instead of the administration's $7.7 trillion would be more plausible. S&P assuming $2 more is still ridiculously low.

The immediate impact of the U.S. credit downgrade will be to cap the credit rating of companies at AA+. The government of the country has to have the highest credit rating in that country because in theory it has no default risk. Economists say that governments can use their ability to tax to pay off their debts. Although as finances deteriorate it is much more likely governments will print money to pay off their debts. No fiscally solvent government ever engages in excess money printing however. The U.S. Fed had increased its balance sheet (a measure of money printing) by $2 trillion since 2007. It doesn't appear that the credit agencies are taking this into account.

The longer-term implications for the lowered credit rating are far more serious.  More downgrades are likely. Interest rates will go up. Money will leave the United States. The U.S. dollar will lose its reserve currency status and this will lower its value substantially. Higher interest rates and a falling currency will both be inflationary. 

The financial world operates very much on image and reputation. Once that's shattered, it can take years to repair it, if it can be done at all.  When Bear Stearns was downgraded in March 2008, the damage to its ability to operate in the financial markets was terminal. The company imploded like an overinflated balloon that had a pin stuck in it. Fortunately, this is not likely to happen to the U.S. - at least not yet.

Disclosure: None

Daryl Montgomery
Organizer, New York Investing meetup
Author: Inflation Investing - A Guide for the 2010s

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.

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