In 1844 the German poet Heinrich Heine, my favourite in any language in which I read verse and whose complete works sit on the book shelf right behind where I am sitting now, wrote “Denk ich an Deutschland in der Nacht, Dann bin ich um den Schlaf gebracht”. In my own modest translation he states, “If I think of Germany in the night, My hopes of sleep have taken flight…”. I currently find the United States to be doing the same for me.
So, hands up anybody who was surprised that Fitch this week chose to downgrade sovereign US debt from AAA to AA+. Hands up anybody who didn’t think that, with a debt to GDP ratio of over 120% and rising and body politic which is in many areas not only creaking but has gone beyond breaking point, the US of A really is an AAA borrower. Hands up anybody who is not somewhat perplexed by the fierce response by markets which should have long been pricing US sovereign credit in line with the obvious and which should have taken the downgrade in their stride. I should hope that hands have been up through all three of the above questions. But I bet they weren’t.
The White House had been aware of the rating agency’s intention to downgrade and had already been furiously lobbying against its expedition. Behind Moody’s and Standard & Poor’s, Fitch is very much the #3 in the ratings game and as such has frequently taken a slightly more independent stance in its attempts to display a USP. In the world of structured credit where I once made my crust, Fitch could frequently be relied on to rate transactions which the big two preferred not to touch. But caveat emptor. A ratings agency’s opinion is only an opinion and not of itself a guarantee of analytical infallibility.
The boundary between AAA and AA+ is very slim. The events which led up to the global financial crisis of 2007/2008 had much to do with credit ratings and with the exercise of arbitraging the algorithms applied by the agencies when estimating the default probability of a security. Strictly speaking, it is not the borrower who is rated but it is the securities in issue. Thus, senior debt and subordinated debt need not carry the same rating and the event surrounding the recent catastrophic and total default on Credit Suisse’s Additional Tier One Capital Notes should remind lenders sauce for the gooses is not necessarily sauce for the gander.
As noted above, the ratings which begin at AAA – or in the case Moody’s at Aaa – and run the line through AA+ or Aa1 to AA or Aa to AA- or Aa3, then BBB+ to BBB-, BB+ to BB- CCC+ to CCC-, CC+ to CC-, C+ to C- until one ends up at D which is assigned to a security in default, are transliterations of the numeric probability of a security defaulting over a given period of time. Thus, and in the Moody’s world, an Aaa bond carries a default probability of 0.00% in one year, rising to 0.0055% over a ten-year horizon. That is not a lot. For an Aa1, the equivalent default probability rises from 0.0003% in a year to 0.055% in ten. By the time the rating on security has dropped to Baa3, its one-year default probability is still only 0.231% and over ten years it is 3.355%.
Towards the lower of the ratings scale we have Caa1, Caa2 and Caa3 where the probability of default within one year is 9.556%, 14.3% and 28.04%, respectively. Over 10 years and for the same ratings, the default probability rises to 26.23%, 35.77% and 44.38%, respectively.
Ratings down to Baa3 or BBB- are formally known as investment grade and below that as speculative grade. The difference between the two was that only investment grade bonds were allowed to be held in discretionary portfolios which were once referred to as “widows and orphans”. Speculative grade, famously rebranded during the heyday of the corporate raiders as junk bonds, were only for the brave. As underlying rates have fallen since the early 1990s and as returns were harder to come by, investors were urged to take on more risk and before you knew it, the two categories had been resprayed and sold as high grade and high yield.
In the same way in which what was once known as third world debt has in my working life been retitled as LDC, or lesser developed countries and then again as emerging markets, so speculative grade debt is now called high yield. You be it is high yield. But does it yield enough to justify itself? Now for the teddy bear in the woodpile. Please bear in mind that as interest rates have fallen and the interest expense has been less stressful to borrowers’ P&Ls, so has the probability of insolvency and default. In the name of so-called “shareholder value”, companies have leveraged their balance sheets to the ying-yangs and with money as cheap as it was, they have been able to do so with near-impunity. Share buy-backs in borrowed money rather than out of retained earnings have become such a common feature of modern stock markets that nobody seems to even wonder what it’s all about.
The recent collapse of Bed Bath and Beyond was a classic case of a company driving itself to the wall in pursuit of positive share price performance predicated not on earnings but on share buybacks. But now we’re getting onto the slippery slope where we have to ask ourselves how much our stockbrokers and independent financial advisers really understand about the credits within the bond funds they buy on our behalf. They like the stock, so they like the bond. Oh dear….
But back to Fitch and the US sovereign credit. The White House was of course outraged and Jared Bernstein, the chairman of the White House Council of Economic Advisers, said in an interview whilst citing a bipartisan deal to raise the debt limit and modestly reduce federal spending: “What was important to the president was to point out not only was the Fitch decision arbitrary and outdated, but his administration has taken action to accomplish things that go in the exact opposite of the markdown”. He went on, “One reason why we punched back hard is because Fitch completely ignored accomplishments under this president, both on fiscal policy and on economic growth.”
I am reminded of the chap who falls off the top of the Empire State Building and just he sails past the second-floor window thinks to himself: “So far, so good.” Yes, the US economy is outperforming that of its European allies, but given the staggering stimulus package which President Biden has boxed through the legislature, is that a surprise? The centre-left to which the Biden administration can surely be assigned has traditionally been tarred with “tax and spend”, as opposed to parties of the centre-right which is where the Republicans are to be found and who are more prone to “spend and spend”. Despite Biden’s centre-left rhetoric, his fiscal policies have been very much of the right as he and his people know that tightening the tax screw would be tantamount to electoral suicide. Buying the missus a diamond brooch on the credit card doesn’t make you any richer and ultimately most likely poorer. I digress.
AAA, or Aaa, ratings come in many forms. The 2007/2008 credit crisis proved that not all AAAs are equal and that some AAAs are significantly more equal than others. Not only did the credit structures arbitrage the ratings models to within an inch of their lives, investors who had enjoyed the same education and training as the structurers and who all had the skills to dissect the CDOs and CLOs and all the other many clever constructs – I think particularly of CPDOs – chose not to and so strode into the credit crisis, eyes wide shut.
Did America and its fiscal or political position change at the stroke of a pen by Fitch’s sovereign credit ratings team? Had they found buried bodies which nobody else had? Had the world of sovereign lending changed, just like that? Of course it hadn’t, and the leap in US treasury yields which the downgrade prompted tells us more about the lamentable risk assessment skills of bond investors than it does of either Fitch or for that matter of the US Treasury Department. Is it not for all to see that a post-January 2025 White House, and hence United States, in the hands of either Donald Trump or Joe Biden is a highly dubious prospect.
Whether Fitch, Moody’s or Standard & Poor’s, the sovereign credit rating cannot limit itself to the outlook for the current or even the next presidency but must include factors which might affect the credit quality of all outstanding debt, 30-year Treasury bonds included. Forecasting credit quality 30 years out is a mugs’ game but they have to do it and I’m afraid I find it hard to believe that anybody could deceive themselves into believing that over that period US sovereign credit will remain the same, let alone improve. Fitch has done nothing other than to confirm what all of us should really have known.
I was yesterday by a reader made aware of an article carried by Bloomberg titled, “US Ramps Up Debt Issuance, Adding Fuel to Selloff of Treasuries”. Treasury officials just shrugged their shoulders and commented: “We see limited or no impact on yields or prices. We continue to see robust demand for Treasury securities and the decision last night (the downgrade) doesn’t change what American investors and people all over the world already know — which is that Treasury securities remain the world’s preeminent safe and liquid asset and that the American economy is fundamentally strong.” That might be true, maybe Swiss federal bonds excepted, but it doesn’t necessarily mean that Treasury paper had been or already is correctly priced. If the economy is so strong, why is the yield curve still inverted and will it disinvert from the front or the back? In other words, will short rates fall, or will long rates rise? Or both? Yikes!
And all this is what disturbed my night’s sleep. What a sad b’stard I am. I know exactly what Heinrich Heine felt like.
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