Investors Downgrade S&P, Buy Treasuries

Eleven days after lowering the credit rating on the U.S. for the first time, Standard & Poor’s is suffering a downgrade among global investors as American bonds are proving world beaters — undermining S&P’s mathematical assumptions — and prompting disbelief among political scientists months after the company upgraded China because of the stability fostered by Communist Party rule.

Since S&P, the New York-based subsidiary of McGraw-Hill Cos., dropped the U.S. to AA+ from AAA on Aug. 5, the yield on the 10-year Treasury note, a benchmark for everything from home mortgages to car loans, has declined to as low as 2.03 percent from a high this year of 3.77 percent, with American debt on pace in August for the biggest monthly gain since December 2008. Interest rates on American bonds are lower today than on most of the countries with AAA ratings by S&P and the Treasury recently financed its outstanding debt at the lowest cost ever.

If anything, the decision from S&P, the largest ratings provider, resulted in an upgrade of U.S. securities as the American bond market outperformed world bond indexes during the period since the downgrade by S&P. Moody’s Investors Service and Fitch Ratings, the two next biggest rating companies, affirmed their AAA rankings on the U.S.

“The market has upgraded U.S. Treasuries,” said Andrew Johnson, the head of investment-grade fixed-income in Chicago at Neuberger Berman Fixed Income LLC, which oversees $85 billion. “Treasuries are still where people run to hide at least temporarily and that’s what we’ve seen over the past week.”

$2 Trillion Error

S&P made its decision, saying the U.S. government is becoming “less stable, less effective and less predictable,” even after acknowledging to the Treasury Department a $2 trillion error in its calculations that by its own methodology could have prevented any change from a AAA rating. Since S&P still insisted on downgrading the U.S. eight months after raising China’s rating, the company’s credibility has come under increasing scrutiny.

“It was really kind of bizarre that they’ve become political analysts,” said Thomas Mann, a congressional scholar at the Washington-based Brookings Institution. “I certainly never look to any of the three rating agencies as a source of expertise, knowledge or wisdom on the political system.”

When Warren Buffett was asked about S&P’s decision, the billionaire chairman of Berkshire Hathaway Inc. said the U.S. should have been upgraded to “quadruple-A.”

The cut left the U.S., whose currency accounts for about 60 percent of the world’s reserves, rated below at least 15 other nations and on the same level as Belgium, which hasn’t had a government since June 2010.


S&P said in July that $4 trillion in budget cuts could be enough for the U.S. to maintain its top grade. Lawmakers agreed on Aug. 2 to raise the nation’s $14.3 trillion debt ceiling and put in place a plan for $2.4 trillion in spending reductions over the next 10 years. When S&P conferred with the Treasury Department before announcing the downgrade, government officials said the firm had overestimated the future national debt by $2 trillion.

S&P changed the numbers and said the error didn’t affect its conclusions that the U.S.’s debt-to-gross domestic product ratio will probably continue to rise in the next decade. S&P “chose to proceed with their flawed judgment by simply changing their principal rationale for their credit rating decision from an economic one to a political one,” John Bellows, acting assistant secretary at the Treasury, wrote on the department’s website.

The Securities and Exchange Commission is scrutinizing the method S&P used to cut the U.S.’s credit rating and whether the firm properly protected the confidential decision, according to a person with direct knowledge of the matter.

Treasury Yields Fall

SEC inspectors are examining S&P’s policies for conducting such analyses and whether those procedures were followed when the firm downgraded the U.S., said the person, who declined to be identified because the inquiry isn’t public.

Ed Sweeney, an S&P spokesman, said the firm doesn’t discuss specific interactions it has with regulators.

While S&P’s downgrade contributed to an equity rout that erased about $6.1 trillion from global stocks between July 26 and Aug. 12, the bond market responded by driving up prices and sending yields to record lows. Yields on 10-year U.S. Treasuries, which drop when demand rises, closed at 2.11 percent on Aug. 10, a percentage point below the 3.1 percent yield on AAA rated French debt and two points below Belgian bonds’ 4.1 percent yield.


Buyers lined up for U.S. debt at last week’s auctions. The Treasury paid a record-low average yield of 2.13 percent on $72 billion of 10- and 30-year notes and bonds, saving taxpayers $647 million in interest payments during the life of the debt, according to data compiled by Bloomberg.

“The market is saying S&P’s rating decision is wrong,” Edward Marrinan, the head of macro credit strategy at RBS Securities in Stamford, Connecticut, said in a telephone interview on Aug. 10. “The Treasury bond is still seen as the ultimate risk-free security.”

S&P said in the Aug. 5 report that the U.S.’s ratio of debt to GDP would reach 79 percent in 2015 and 85 percent by 2021. In 2009, when the rater affirmed the U.S.’s AAA rating, analysts wrote that the ratio would approach 90 percent by 2013.

“They have made no connection between any minimum required metrics and various ratings tiers,” Glenn Reynolds, chief executive officer of bond research firm CreditSights Inc., said in an e-mail. “S&P took a soft variable and used it to downgrade the U.S. on a very narrow set of forward political assumptions.”

‘So AA+’

The decision to cut the rating was reached by a team of sovereign debt analysts, including Toronto-based Nikola Swann, London-based David Beers and John Chambers, who works in New York. They score countries on five criteria, including political risks and debt burden. Sweeney, the S&P spokesman, declined to say how the U.S. did in those categories or how many analysts were on the committee.

Swann, the lead author of S&P’s report, said the U.S. lost the top grade because political leaders failed to demonstrate that they were serious about cutting the national debt.

“We really just came to the view that if it’s anything less than $4 trillion it’s hard to argue they’re seriously doing anything about it,” Swann said at conference with reporters on Aug. 9. “So we came to the view, well they’re not seriously doing anything about it, so AA+.”

Literature Degrees

Swann worked as an economist in Canada’s Department of Finance prior to joining the rating company in 2002. Beers, managing director of sovereign ratings, worked at Salomon Brothers before joining S&P in 1990, and has a master’s degree in economics from the London School of Economics. Chambers studied literature at Grinnell College in Iowa and Columbia University in New York.

“You have to work on Capitol Hill to know what the sausage factory looks like,” Robert Auerbach, who worked in Congress for 11 years and is now a professor of public affairs at the University of Texas in Austin, said in a telephone interview on Aug. 11. “The people at S&P are entirely wrong. This is how a democracy works.”

Fitch affirmed its AAA rating for the U.S. today and said the outlook is stable. New York-based Moody’s reiterated its top Aaa rating for the U.S. in an Aug. 8 report, calling the debt accord a “positive step.” Steven Hess, Moody’s senior credit officer, said the second-biggest ratings provider examines “actual policies as opposed to the political debate.”

Reserve Currency

“We now see at least both parties having the same goal of deficit and debt reduction over the long term, even though more needs to be done,” Hess said in a telephone interview that day. “More important to us than how contentious the process is, does it produce results?”

Moody’s, which has rated the U.S. Aaa since 1917, said in the report that the dollar’s role as the world’s main reserve currency means “the U.S. government can support higher debt levels than other governments.” The greenback represents 60.7 percent of the world’s currency reserves, compared with 26.6 percent for the euro, which has the next biggest portion, according to the International Monetary Fund in Washington.

The dollar climbed against 14 of its 16 major peers last week as investors sought a refuge for their assets with markets around the world fluctuating. Treasuries have returned 2.27 percent this month, compared with 1.35 percent for government debt worldwide excluding U.S. bonds, according to Bank of America Merrill Lynch index data.

Treasury Holdings

Asian investors are likely to retain their Treasury holdings for now, with options limited by the region’s foreign- exchange rate policies. Japan, the second-largest international investor in American government debt behind China, sees no problem with trust in the securities, a Japanese government official said on condition of anonymity. Russia said the one- step cut “can be ignored.”

China increased its holdings of U.S. government debt by 0.5 percent to $1.17 trillion in June, the third straight monthly increase, while other foreign investors were sellers of Treasuries for the first time since 2009, according to data released yesterday by the Treasury Department.

The gap between political parties has grown, said former Congressman Bill Frenzel, who served as the ranking Republican on the House Budget Committee. In the Senate, the Republican minority has used the filibuster to block debate more frequently, with the number of cloture votes — attempts to break a filibuster — doubling to 112 from 2007 to 2008 from 54 in 2005 to 2006, when the Democrats were in the minority, according to data on the body’s website.

‘So Highly Polarized’

“Members of Congress and the voting blocs that support them seem to be so highly polarized that there is no opportunity to achieve a compromise,” Frenzel said in a telephone interview. “S&P is smart enough to understand that you can’t balance the budget on discretionary spending.”

Marketable U.S. government debt outstanding has risen to $9.4 trillion from $4.34 trillion in mid-2007 as the government borrowed to bail out the nation’s banking system and lift the economy out of recession. The U.S. went from budget surpluses averaging $139.7 billion from 1998 through 2001 to a deficit of $1.29 trillion last year, Bloomberg data show. That hasn’t raised the country’s borrowing costs. Average debt yields of 1.5 percent in July compare with 6.54 percent in 2000.

‘Fuel a Bubble’

S&P, Moody’s and Fitch engaged in a “race to the bottom” to assign top grades to mortgage-backed securities at the request of the banks that paid them, according to a report released by a Senate panel in April. About 90 percent of AAA rated bonds backed by subprime mortgages from 2006 and 2007 were later downgraded to junk status, the Senate Permanent Subcommittee on Investigations said in the report.

The ratings companies “helped fuel a bubble which, when popped, caused government deficits to explode,” said Robert Reischauer, who led the Congressional Budget Office from 1989 to 1995. “Then the same group comes back to you and says, ‘We’re worried about your ability to deal with these deficits.’”

China has been upgraded five times by S&P since 1999, Bloomberg data show. “We believe the Chinese authorities would respond to future threats to financial stability with timely measures, based on our observations over the past two years,” S&P said Dec. 16 in a statement.

The Communist Party of China has a “monopoly” on power, meaning the country isn’t an electoral democracy, according to Freedom House. The nine-member Politburo Standing Committee sets policy, the Washington-based human-rights advocacy group says on its website.

‘Modest Indebtedness’

S&P also cited China’s “modest indebtedness” and “exceptional” growth potential as reasons for the one-step upgrade to AA-. The country was cut one level in July 1999 to BBB from BBB+, China’s only downgrade since it was assigned a ranking in 1992, as S&P warned that government spending was hiding the extent of the nation’s economic slowdown.

In the U.S., S&P’s forecasts changed as the debt ceiling approached. On April 18, S&P said that there was a one-in-three chance of a downgrade within two years. Three months later, the company said the likelihood had risen to 50 percent in the next 90 days. The Senate voted Aug. 1 to raise the nation’s debt ceiling for the 79th time since 1960.

‘Downright Opaque’

While lawmakers pushed the debt-limit debate to the deadline set by Treasury, protracted disputes led to compromises in the past. A bipartisan bill to balance the U.S. budget won congressional approval in 1997 after government shutdowns and a 2 1/2 year tug-of-war between a Republican Congress and Democratic President Bill Clinton. The bill achieved most of its savings by slowing the growth of Medicare and Medicaid.

Basing credit ratings on politics makes them “wholly arbitrary and downright opaque,” CreditSights’ Reynolds wrote in an Aug. 7 report. By relying on political analysis to downgrade the U.S., S&P is discounting the views of bond investors, who’ve shown they’re willing to lend to the U.S. at rates that imply almost no risk, he said.

“There are two things you can count on — the market is smarter than S&P and the U.S. will not default,” Reynolds said.

By Zeke Faux and John Detrixhe
Courtesy of Bloomberg News

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