Blaming the Referee

Over the past couple of days a number of politicians have jumped into attack S&P for their decision to downgrade United States sovereign debt. The main theme in these attacks has been that S&P missed sub-prime and therefore lacks credibility. However, it is interesting that the people who have been doing the criticizing have had just as poor records with regards to the financial crisis of 2008.

Yesterday in an exclusive interview with CNBC, Timothy Geithner said, “S&P has shown really terrible judgment and they’ve handled themselves very poorly”. In order to further diminish the credibility of their decision he said “just look at the quality of judgements they’ve made in the past”

Paul Krugman was equally irate with the decision. He claimed that S&P lacks credibility and showed an amazing amount of chutzpah to downgrade the debt. On top of their having missed subprime, he uses the example of Japan to prove how they have been wrong in the past as well in similar circumstances.

He wrote, “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.”

Krugman, however, is ignoring the fact that a downgrade is not a prediction by a rating agency that a country will default. When S&P cut Japans rating they weren’t making a prediction that Japan was going to default and were thereby proved wrong when Japan remained solvent. S&P’s definition of a AA rating is “AA: An obligor rated ‘AA’ has very strong capacity to meet its financial commitments. It differs from the highest-rated obligors only to a small degree.” So S&P was RIGHT when they predicted that Japan had a strong capacity to meet their debt obligations and they did. Japan though has enormous debt – over 200% ratio to GDP – some say the highest in the world. It seems pretty reasonable that S&P wouldn’t assign them the highest possible rating, reserved for only the most fiscally responsible countries.

After Krugman rants about S&Ps decision he goes on to admit that the US does have serious problems: “And yet America does have big problems. No, what makes America look unreliable isn’t budget math, it’s politics. And please, let’s not have the usual declarations that both sides are at fault. Our problems are almost entirely one-sided — specifically, they’re caused by the rise of an extremist right that is prepared to create repeated crises rather than give an inch on its demands.”

Political uncertainty is one of S&P’s main criteria with regard to Sovereign debt, so Krugman actually makes a strong argument for the AA+ rating. While he thinks the finances are strong, he thinks there is concern with the political climate. That seems exactly sufficient to merit a AA+ rating as the AA+ rating only differs from the AAA in that it encompasses a slight uncertainty.

Geithner too talked about problems with the fiscal picture. He said, “There’s no surprise that the U.S. has a long-term and unsustainable fiscal position,” he said. “We believe that. The president believes that. That’s why he’s been fighting so hard to bring people together to try to deal with it.” Given that both men admit that there is at least some challenges and uncertainty a AA+ rating seems more than reasonable and even a bit generous.

I thought the most amazing thing though was that both men challenged the credibility of S&P based on the subprime crisis. Surprising because Krugman and Geithner have both had pretty weak credibility with regards to the crisis as well.

In fact during the formative years of the housing bubble when the Fed was still lowering interest rates, Krugman said in an interview. “During phases of weak growth there are always those who say that lower interest rates will not help. They overlook the fact that low interest rates act through several channels. For instance, more housing is built, which expands the building sector. You must ask the opposite question: why in the world shouldn’t you lower interest rates?”
Excessively low interest rates is widely agreed to be one of the main causes of the crisis.

Geithner was also equally poor in his predictions of sub-prime. Before becoming Treasury Secretary, Geithner was the president of the Federal Reserve Bank of New York. He voted with Bernanke and consistently agreed with the general consensus of the Federal Reserve whose Chair (Bernanke) was still laughing off the idea that the housing market was in a bubble even in the later years of the bubble.

Krugman and Geithner came off as hypocritical and in denial. To use a sports analogy, they reminded me of the types of athletes who blame the referees after a loss. It’s the S&P’s job like a referee to make an impartial analysis and judgement and there is no real reason to believe that they are not doing anything but their best to provide objective analysis. Krugman and Geithner could have come out and said the S&P decision was fair and reflects the fact that while we are still a very solid country, the AA+ rating acknowledges that we have some political and long term fiscal sustainability problems. Nonetheless, we plan to work our hardest to regain the AAA rating. They could have accepted the loss of AAA status with a bit of integrity, instead they whined and blamed the refs.

Thoughts On Interest Rates

Here are some thoughts on the S&P debt downgrade as well as a discussion of interest rates.

Firstly, I don’t think that interest rates are going to be that affected at least soon. If you are an investor, it is hard to imagine that you haven’t already done your own calculations about the creditworthiness of the US government and all the other factors that affect interest rates. So for instance if you are a big bond investor, it’s hard to imagine that haven’t already analyzed the governments balance sheet and assessed the political climate – so just because one rating agency moved their credit rating of US sovereign debt from AAA to AA+, it unlikely that you would all of sudden start dumping your holdings of treasuries. So for example, if the analysts at Pimco had decided to buy and hold government bonds, I can’t imagine that they would alter their decision based on S&P having a slightly different analysis than them (Moody’s and Fitch still agree with the AAA rating).

So in the short term I don’t think we are going to get a spike in interest rates. That being said, I think this event is significant in that it sheds light onto the fact that many factors driving interest rates are going up in the long term.

Here is a list of factors that i think over the long term will put upward pressure on interest rates.

1. Fed Funds Target Rate – It’s hard to imagine that the fed can keep interest rates at 0 forever. Someday interest rates will rise back to a more normal level of 4 to 5%.

2. Inflation – Milton Friedman once famously said that “inflation is always and everywhere a monetary phenomenon”. With massive money printing through several quantitative easing programs and ultra stimulative monetary policy, it is hard to imagine that sooner or later it won’t show up as inflation. It is likely that inflation has already started to show up in higher food and energy prices.

3. Credit Premium – Although, I said the S&P downgrade wouldn’t likely affect interest rates severely in the short term – it signals that there might be a higher credit premium built into treasuries at some point. It will be interesting to track the premiums on credit default swaps that insure US government bonds. I think that the issue of demographics will be a large factor that strains government finances. There will be many more Americans eligible for social security retirement benefits as well as increased health care spending over the coming years. Over the next 20 years roughly 80 million Americans will be eligible for social security. According to the US Census, the dependency ratio measured as the percentage of people over 65 to those of working age population will rise from 22% to 38% in the next 25 years.

4. Liquidity premium – This could be a factor but only once a crisis unfolds. The treasury market will remain liquid unless there is an investor panic of sorts. This would likely result in a flight to safety to Gold.

5. The End of QE – The end of Quantitative easing means less demand and that the Fed will no longer be suppressing long term yields.

6. Foreign demand – Countries like China, Russia and Brazil have been vocal about their displeasure with the United States handling of their finances. It is unlikely that China will suddenly dump US bonds but they could just let some of it mature or diversify their investments a bit more. That could also mean lower demand.

7. Supply – More debt (more supply) since the debt deal that was passed did very little to affect the upward trend of debt, this will also put upward pressure on interest rates.

I still don’t think that interest rates are going up severely in the short term. However, i do see many long term factors that will put pressure on interest rates to rise. Just like in the last crisis, problems only started unfolding once interest rates started to rise and homeowners with adjustable rate mortgages couldn’t afford to pay the interest payments, the US government will also have much greater problems once interest rates start to rise. That will likely be a weight on the entire economy.