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Monday, August 8, 2011

When debt is sovereign and ledes are burried

John MacBeath Watkins

One of the three main rating agencies has dropped the American sovereign debt rating, and the response of the markets has been to sell stocks and pile into American sovereign debt. By most readings, this means the Standard & Poor rating doesn't matter. I think that reading is wrong.

The rating change is a very political move, and the response has everything to do with politics. How do we know the rating change was political? Well, the original documentation S&P gave the White House supporting their downgrade contained a $2 trillion error, as the White House documents here.

 The White House pointed out the error, but S&P went with their original conclusion anyway. That's where things get interesting. As Ezra Klein points out:

"In the original version, they say that $900 billion would mean net public debt drops from an estimated 93 percent of GDP in 2021 to 87 percent of GDP. But in the second version of the report — the one they wrote after they discovered their $2 trillion mistake — they revised their estimate for America’s baseline debt path down to “74% of GDP by the end of 2011 to 79% in 2015 and 85% by 2021.” In other words, S&P’s technical correction improved our deficit outlook by more than letting the high-end tax cuts expire, which S&P had said would raise enough money to stabilize our rating. If the numbers mattered, then by S&P’s own logic, that should have changed their opinion of our finances."

Now, if you are getting the feeling that the folks at S&P are not the sharpest knives in the drawer, you're not alone. An anonymous poster on a blog with the interesting name Economics of Contempt asserts that:

"Look, I know these S&P guys. Not these particular guys — I don’t know John Chambers or David Beers personally. But I know the rating agencies intimately. Back when I was an in-house lawyer for an investment bank, I had extensive interactions with all three rating agencies. We needed to get a lot of deals rated, and I was almost always involved in that process in the deals I worked on. To say that S&P analysts aren’t the sharpest tools in the drawer is a massive understatement.

"Naturally, before meeting with a rating agency, we would plan out our arguments — you want to make sure you’re making your strongest arguments, that everyone is on the same page about the deal’s positive attributes, etc. With S&P, it got to the point where we were constantly saying, “that’s a good point, but is S&P smart enough to understand that argument?” I kid you not, that was a hard-constraint in our game-plan. With Moody’s and Fitch, we at least were able to assume that the analysts on our deals would have a minimum level of financial competence."
 I feel better about all those bonds we've bought based on S&P ratings already. I don't know why they set their hearts on lowering the rating for U.S. sovereign debt, but S&P seems to have made up their minds regardless of the numbers.

But the point is, the market reaction to the rating is bound to be an economic calculation based on the political consequences of the downgrade, because it certainly isn't a straightforward reaction to a belief the debt is less secure than we thought last week. As the New York Times noted in a deeply buried lede,

"Guy LeBas, chief fixed-income strategist for Janney Montgomery Scott, said higher prices for bonds were 'a testament to the fact that global investors view U.S. bonds as the safe-haven asset choice.'"
 That paragraph, by my count, is 15 graphs into a story that's supposed to be about the consequences of the downgrade, and it's the first reference to how bond prices were responding to the downgrade. Guys, I used to do this for a living, I've been a business editor, and if I were writing something about the consequences of a change in the rating of U.S. sovereign debt, I'd make damn sure there was something about how the market for said debt responded to the downgrade near the top of the story, not 15 graphs in.

This is emblematic of  the press coverage of the entire debt debate -- don't worry about the substance of the matter, print something that perks up the hind brain. I understand the motivation, but it amounts to writing the "dog bites man" story when the evidence points to a much better, "man bites dog" story. But of course, the New York Times is a bellwether, not a watchdog. From Wikipedia: "The term is derived from the Middle English bellewether and refers to the practice of placing a bell around the neck of a castrated ram (a wether) leading his flock of sheep.[1][2] The movements of the flock could be noted by hearing the bell before the flock was in sight."

Aaaah. I've at last found a simile for the "castrated ram" that helped lead us into Iraq. But back to the matter at hand.

The fact that stocks are down and bonds are up means the market thinks stocks are riskier than bonds. The market, that many-headed beast whose appetites tell us what the consensus wisdom (or momentary panic) affecting the populace is, thinks the consequences of the downgrade are that government will pay its debts, but will fail to stimulate the economy.

Failure to stimulate the economy will mean more companies will fail, and the rest will make less money and distribute smaller dividends and realized less equity gain. Money is flooding into sovereign debt. Part of this is because money held as cash isn't stuffed into mattresses, it goes into money market funds that seek secure, liquid investments without much regard for high returns -- that is, short-term borrowing by entities unlikely to default.

And it's flowing out of stocks, because the downgrade makes government less likely to do what it should be doing in the present circumstances, finding a way to get the country back to work.

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