The Truth Behind the U.S. Credit Rating Downgrade - Capital Ingenuity Audio Blog - 8/10/11

By Ryan Snefsky

This is the very first recording of the Capital Ingenuity Audio Blog! This is a discussion about the implications of the recent downgrade to the U.S. credit rating, the politics behind the rating agencies, and the relevance of the rating agencies going forward.

"Hi, I’m Ryan Snefsky with Capital Ingenuity and you are listening to the very first recording of the Capital Ingenuity Audio blog! Today is August 10th, 2011.

Alright, so everybody’s been talking about how the stock market has been extraordinarily volatile over the past few days. The volatility is partly due to the fact that last Friday, August 5th, Standard and Poor’s, or S&P, cut the credit rating of the United States to AA+ from AAA status.

Since the downgrade, I’ve been getting a lot of questions. Was this a good call? Was this a bad call? Why did only one of the big three credit rating agencies issue a downgrade? Are the credit rating agencies even credible any more?

So, today I want to address a few of these questions so you have a better idea of what this downgrade is all about.

I’ll start by saying that in my opinion, this downgrade is without question, the right call and here’s why.

Imagine for a second if you had a ton of debt and you just so happened to have a perfect credit score with each of the three major consumer credit rating agencies.

Now, the idea of this in itself is pretty ridiculous, because there is no way you would have a perfect credit score if your debt to income ratio was anything close to the debt to GDP ratio of the United States.

But, humor me here for a minute. Do you think that any one of the consumer credit rating agencies would ever tell you, “Look, if you expect to keep your perfect credit score, you’re going to need to increase the total amount you’re allowed to borrow?”

Absolutely, not! Why? Because that’s completely ridiculous! It’s ridiculous because the risk of you defaulting on your debts at some point in the future goes up, as you take on more and more debt, not down!

Well, prior to the debt ceiling being raised, this is exactly what each of the credit rating agencies was telling the United States Government.

Prior to the debt ceiling being raised, I didn’t think that any of United States credit ratings issued by any of the big three were worth the paper they were printed on. Now I think the only one that’s actually got it right, is S&P.

Now, keep in mind what S&P is suggesting here. A AA+ rating is still a fabulous rating.

They’re not suggesting that the United States doesn’t have the ability to pay it’s debts. If they were suggesting that, they would’ve downgraded to something far lower than AA+.

What they’re suggesting is that U.S. treasuries shouldn’t be considered as safe as they were in the past. Frankly I think that sounds pretty reasonable after our two political parties just held our credit rating hostage in the debt ceiling negotiations.

Let’s keep in mind that on July 30th, which was just two days before the deadline, the United States had no ability to pay all of its bills in just a few days.

Now, many people in the media lately have attacked S&P for making the downgrade, including Treasury Secretary Timothy Geithner.

He was quoted in an interview regarding the downgrade as saying, and I quote, “I think S&P’s shown, really, terrible judgment.”

Now, Secretary Geithner more or less HAD to make that claim for two reasons.

First, a few days before this particular interview, he stuck his neck out and basically assured us that none of the credit rating agencies were going to issue a downgrade.

So now that a downgrade actually did occur, he has to claim that S&P is the problem here, more so than the dysfunctional negotiations of the lawmakers.

Second, the Treasury Secretary is appointed by the President, who’s coincidentally up for re-election in 2012.

So, by suggesting that S&P doesn’t have its act together, Secretary Geithner can effectively divert blame from being pointed at the administration.

Now in fairness, S&P actually gave the administration an out because they DIDN’T have their act together.

Apparently, when S&P originally notified the white house on Friday that a downgrade was coming, they forgot to dot their I’s and cross their T’s.

S&P supposedly made a mathematical error and over estimated future U.S. debt by about 2 trillion dollars.

I seriously don’t know how a problem like that, on an issue that’s so important, gets over looked. But, it did.

Anyway, the white house called out S&P on their error, and S&P acknowledged it, but still went ahead with the downgrade.

So by literally not checking their work, they opened themselves up to a plausible counter attack by the white house.

Now, that being said, while S&P did make a tremendously ridiculous error, that doesn’t change that fact that the United States deserves to be downgraded.

Again, I reiterate, if you cannot pay your bills without having to increase your borrowing limit, you’ve got some serious problems. And if you have serious problems, you probably don’t deserve to have an absolutely perfect credit rating.

Now, prior to the downgrade, both Moody’s and Fitch, reaffirmed their top credit ratings for the United States.

So many people have been asking, why did only one of three major rating agencies issue a downgrade?

Well, remember earlier when I said that prior to the debt ceiling deal, I didn’t think any of the ratings were worth the paper they’re printed on?

This is because there’s some serious consequences to the credit rating agencies themselves, if they issue a downgrade for the United States, particularly if all three agencies were to downgrade around the same time.

Here’s the deal. Generally speaking, the assumption is that a credit rating downgrade leads to higher interest rates for treasury securities.

If they’re suddenly perceived as being riskier, then investors will want to be paid more in the form of higher yields, or interest rates, for assuming a bit more risk.

Now, we haven’t been seeing this so far in the case of the S&P downgrade, because there is so much risk associated with Europe’s economic troubles, at the same time that we’re learning that our own economy is not recovering as fast as we originally thought.

If the problems in Europe were not such a big deal right now, the prices of treasury securities would likely be pressured slightly downward.

But as long as Europe’s problems overshadow ours and the Fed continues to suggest the likelihood of low interest rates for an extended period of time, prices of treasury securities should remain high.

But if we assume that normally interest rates would rise in the presence of multiple downgrades, we would potentially be looking at what is known as a global re-pricing of risk.

The idea here is that the United States Government has long been perceived as being the absolute safest place in world to put money.

So if the United States was suddenly widely perceived as being less safe than it once was, then it stands to reason that the bonds of any entity that was previously perceived as being less safe than the United States, should also be considered at least a little bit less safe than before; and therefore should have their yield’s increased as well.

Now if the yields of bonds everywhere were to go up, then the cost of borrowing goes up for any entity that wants to raise money through bonds.

As a matter of supply and demand, when the cost of borrowing goes up, entities have less demand for issuing bonds.

Now, the problem for the ratings agencies is that they get paid when entities such as Governments and corporations want to issue bonds.

So if downgrading the United States causes less demand for issuing bonds, the downgrade also effectively reduces the income of the ratings agencies.

So now that you can see the direct consequences to the rating agencies of issuing multiple downgrades at or around the same time, you can see why I didn’t put an ounce of worth in the credit ratings of all three agencies before the current downgrade.

I actually have more respect for the S&P rating now, and I continue to think that the credit ratings for the United States that have been reaffirmed by Moody’s and Fitch are absolutely worthless.

Alright, hopefully this gives you a better idea of what’s going on with the S&P downgrade and with the rating agencies in general.

As a final note, I’d like to mention that the opinions expressed in this audio blog are solely my own and that none of the opinions should be considered financial advice.

And most importantly, I know that this audio blog is nothing without listeners like you, so I sincerely thank you for listening."