Rating Agencies Causing the U.S. Debt Crisis?

The Wall Street Journal’s Holman Jenkins Jr. see a problem in Rating Agencies (Moody’s, S&P, Fitch) actually anticipating default:

But now we have a new problem. The rating agencies, especially Standard & Poor’s, have decided to join the politicians in turning an artificial crisis into a real one. S&P says it plans a U.S. debt downgrade, regardless of any debt-ceiling outcome, unless it sees a “credible” plan to reduce future deficits by $4 trillion over the next 10 years.

This has become the real worry for Wall Street, but why? America’s spending debate does not remotely make it any more of a default threat than it was a week or month or year ago. America’s IOUs are still completely acceptable to the markets.

Rating Agencies generally rationalize market opinion the way politicians rationalize whatever talking points are popular with their base. They aren’t leaders, rather focal points who artfully persuade many who don’t follow or trust markets, that the market is generally correct. When I worked at Moody’s, we took a beating from KMV because this firm showed that their purely quantitative ‘distance to default’ outperformed Agency Ratings. A distance to default metric is basically a simple function of market cap (higher is better), volatility (lower is better), and debt (lower is better), which is basically a market cap metric (volatility and market cap are positively correlated). All I can say is that the ratings agencies said they ratings were not comparable, and then Moody’s bought KMV and such embarrassing information is not mentioned much (yet never repudiated).

So, ratings agencies are symptoms, and when things trade at AAA they get those kinds of ratings. As the markets are now questioning the AAA rating of the USA, it’s only reasonable the Ratings Agencies too would ask these questions. Jenkins remarks that

There’s a reason the monumental unfunded liabilities of Social Security and Medicare are not counted as part of the federal debt—they don’t have to be paid

Which is what many said about the obligations of Latin American before the 1980 debt crisis, or what Russian investors said before the 1998 default. They don’t have to pay these obligations, but given the incentives to pay senior citizen and public employees, or foreign debtholders, I would bet on them defaulting. Debt payment is based on priorities, and often governments choose to pay others before their debt holders.

For Jenkins to imply that rating agencies should, as a rule, wait until the market trades debt at a certain level to downgrade or even discuss a downgrade only makes the ratings purely redundant. Without the option to draw a line proactively, the charade is over and Ratings Agencies lose whatever meaning they have.

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