A credit rater that overreacted and overreached

Credit-rating agencies serve a valuable role in the world’s markets by helping to measure risk. However, in the case of Standard & Poor’s recent downgrading of U.S. credit, we believe they got it wrong.

There is no reasonable scenario in which the U.S. government would default on its debt.

First, we must look to history. The U.S. federal government hasn’t had a hard default since its dawn. The closest the country has come to default was in 1933, when it avoided default through restructuring. Despite difficulties, the United States always finds a way to meet its obligations.

Second, from a political-economic perspective, it is the most powerful country in the world, with the largest, most innovative economy. It continues to play a leadership role in international organizations and provides more than $35-billion (U.S.) in foreign assistance annually.

Third, utilizing a corporate-styled risk analysis, it is hard to imagine a scenario in which the U.S. government defaults. Like a corporation experiencing medium-term financial stress, it has several options. The United States controls valuable resources and undervalued assets on its balance sheet, all of which it could sell or pledge to meet debt obligations. In addition, it could immediately move to lower its expenses by reducing the activities it undertakes, with some significant disruption, of course.

It is also useful to compare the United States with other S&P sovereign-debt ratings on a broad set of measures. Is the U.S. a worse credit risk than France or the United Kingdom, both of which have lower GDP per capita, higher public debt to GDP, and lower growth prospects than the United States?

This is not to demean France or the U.K., but simply to outline the lack of consistency in the S&P ratings. Is the U.S. decidedly weaker than the countries listed by S&P as triple-A when one reviews the statistics? The answer is “no.”

The fractious nature of the U.S. political system does present problems, which became extremely obvious in the days running up to the recent raising of the debt ceiling. The issues are real and divisive, but there are reasonable and viable solutions that can and will be found. Given this, U.S. government debt remains one of the safest and most liquid investments on the planet.

Why, then, did S&P decide to downgrade its credit rating of U.S. debt? There are two somewhat related explanations.

The first is a political one. It is obvious that the debate in the United States about how best to get the country’s fiscal house in order needs to shift. More action is required. However, we suggest that S&P is playing an activist role in this regard and, in doing so, it is operating outside the bounds of its mandate and overplaying its hand.

The second is that the credit-rating agencies have come under severe criticism in the recent past, particularly from politicians and bureaucrats. The agencies are emotionally charged and may be overreacting and overreaching as a result.

S&P well knows that its ratings often have a real-world impact. If the agency’s opinion is based on sound economic analysis and exigent financial circumstances, it shouldn’t hold it back. However, given the potential impact of its actions, S&P should ensure its opinions are based on sound clinical analysis and are fully reflective of what it is being asked to rate.

Unfortunately, in this case, it appears that S&P may have entered the realm of political debate in Washington, while not fully considering the economic and social “collateral damage” of its actions.

Once the current tumult has settled, we believe it will be important to have a dialogue about the rating agencies, their processes and their roles and responsibilities, particularly with regard to sovereign debt.

In the meantime, we hope that Washington will speedily find a viable path forward and that markets will not overadjust to one rating agency’s foray into political process.


From Tuesday’s Globe and Mail