Rating the Rating Agencies

 

       The major rating agencies (Standard & Poor's (S&P), Moody's, and The Fitch Group) failed miserably when they severely overrated mortgage backed securities prior to the 2007 – 2008 recession. What was supposed to be the first line of defense for investors turned out to be a gross misrepresentation of the riskiness of the investments and by extension the true market value of the securities? If these securities were properly rated to reflect the risk of the underlying assets (home loans) it is probable that the housing bubble would have never developed and the entire recession could have been avoided. 

 

       Currently planet earth consists of over 190 nations. Of these, fewer than 20 nations earn the top rating of the three major credit rating agencies. Moody’s short definition of a top rated entity is; “Obligations rated AAA are judged to be of the highest quality, with minimal credit risk.”

 

Envision a world where there exists a fictitious country that had an economy equal to that of the United States, and this country has no national debt, no unfunded liabilities, a balanced budget and a positive economic outlook for years to come. It stands to reason any nation the size of the United States who sported such strong financial numbers would deserve the highest possible rating. 

However, the United States as it exists today in my opinion sports a balance sheet that would barely qualify it for a rating much higher than junk bond status. The financial condition of the United States looks more like the balance sheet of Greece, Spain and Italy. The three countries that personify what a poor economy looks like and in recent times caused negative ripples in many of the world’s bond and stock markets.

 

       The United States is expected to have a national debt approaching $20 trillion by the time president Obama leaves office. We have not done a very good job on spending, borrowing about a trillion a year over the last 6 years just to meet budget expenses. In addition by 2017 the United States will need to budget at least $1 trillion a year just to cover debt interest expense. The current national debt is equal to at least 3 years of all the tax revenues collected from both individual and corporate income taxes. In a normal interest rate environment it would require at least 20% of all tax revenues just to pay the interest on the national debt. This statement assumes an interest rate of at least 5%, which is less than the average interest rate over the 45 years preceding the 2007 – 2008 recession. Add to that around $90 trillion in unfunded liabilities, perpetual budget overruns and you have a picture of the United States as it exists today.

 

       In my opinion the major rating agencies are currently misrepresenting the true value of the treasury securities that comprise the national debt. Moody’s and The Fitch Group currently assign their top rating to the sovereign debt of the United States in spite of all the financial issues I just identified. (S & P assigned the second highest rating.) Two of the three rating agencies rate the creditworthiness of the United States as perfect, and equal to the creditworthiness of the fictitious nation described above, a nation with a perfect balance sheet. 

 

       How the rating agencies justify their ratings is beyond me. I confess that I don’t have a clue about the process the rating agencies use to determine the credit status of any entity but I don’t believe that it should in any way distract from my opinions and conclusions. After all, I believe my opinion are just stating the obvious. 

 

       Any corporation whose balance sheet listed more liabilities than assets would be considered bankrupt. The rating agencies apparently believe that the balance sheet of sovereign nations deserve different considerations than a corporation. This of course is correct given that sovereign nations have the power to regulate its income and spending. However this power is often abused by politicians because spending brings in votes and taxes chases voters away.

 

       There is no question that the United States is far and away the largest economic power on earth. This of course raises the question “Why can’t the United States live within its means?” This is a matter for a separate discussion, but I will point out that we have the added responsibility of being the protector of the free world, which requires an overwhelming and costly military presence. In addition through the use of foreign aid we attempt to guarantee our sphere of influence.

 

       In my opinion the best gauge of a country’s financial stability is the ratio of debt to GDP. That is the total (gross) amount a country borrows as a percentage of it gross domestic product. Though the following stats from the IMF may be a little dated they do illustrate my point.

 

                      Country                                Stat. Date                    Debt to GDP Ratio

 

                  United States                          February 2014                         106%

                         Italy                                    June 2012                             108%

                        Spain                                   April 2013                             167%

                       Greece                                   June 2011                             174%

 

According to Eurostat the average debt to GDP ratio of the 28 member countries of the European Union was 87% (2013). The following chart illustrates this.

 

                                                       (The chart appears in the book)

 

At a 106% debt to GDP ratio, the financial stability of the United States can only be described as poor. Yet despite of this glaring black eye the rating agencies still give the United States a stellar credit rating. Perhaps the rating agencies rate sovereign debt on a curve. They may view the sheer size of our economy as our strongest point and conclude that size alone would be a major factor that will enable us to better withstand major financial shocks. If this is the case they are absolutely wrong. The bursting of the housing bubble affected every single and multi-family home in the United States. To the best of my knowledge the fact that the US housing market was the largest in the world, had no effect in the way this crisis played out. I believe the rating agencies do view the size of the American economy as a major positive, after all what other reason could they give for issuing their top rating.

 

       I am of the opinion that once the Federal Reserve ends its bond buying program and investors wise up to the house of cards that supports our financial structure, investors will demand higher rates on the treasury securities they purchase. The purpose of the extremely low interest rate policy put into effect by the Federal Reserve at the start of the 2007 – 2008 recession was to stimulate the economy. However, in my opinion even the Federal Reserve was unsure of its own ability to keep interest at the low levels they had set. The massive debt accumulated during the early stages of the recession had damaged the creditworthiness of United States. In order to keep interest rates down the Fed undertook an unprecedented action and started a massive bond buying program, purchasing $75 billion a month. This action in fact was an insurance policy undertaken by the Federal Reserve to prevent bond traders from pushing interest rates up. Their total purchase exceeded $4 trillion. In my mind this action only solidifies my belief that without Fed intervention, interest rates would surely rise and the Fed was aware of this. 

 

       The Feds bond buying program is scheduled to end in late 2014. I believe shortly after that time bond traders will demand higher interest rates before adding to their positions. At the present time they cannot do anything to offset the Feds action, but once the bond buying program ends I believe interest rates will trend upward, possibly sharply upward. The reason is the deterioration of the financial condition of the United States that has taken place since the start of the recession and the institution of the Feds (artificially) low rate policy. I also believe that the Wall Street slogan of “Don’t fight the Fed” will go down in flames, and that many traders worldwide will liquidate their investments or hold back on new investments until they receive higher rates to compensate them for the added risk in owning Unites States debt. I believe the Fed will appear hapless as they will be unable to stop it. 

 

       As stated above, if the major rating agencies factored in the size of the United States economy in assigning their best or near best rating they are severely off base. When it comes evaluating the creditworthiness of a country whose financial condition is in question, being the biggest is not an asset, it’s a liability, because it will require a larger effort for a nation to get it house in order. The major credit agencies are doing this country and those who invest in our debt a severe disservice because they are masking the true status of our economic condition and by extension the risk in investing in treasury securities that support the national debt.

 

       Because of the Feds low rate policy the purchaser of the 10 year Treasury note in 2012 will be stuck with an interest rate of about 1.75% through 2022. If an investor made that same purchase today (August 2014) he will be stuck with an interest rate of about 2.5% through 2024. If my assumptions are correct by 2020 the 10 year Treasury will yield between 5% and 7%. In fact I believe these securities should yield the higher rates right now. The Feds low rate policy enforced by their bond buying program prevents this from taking place. Once the bond buying program ends as previously stated I expect interest rates to rise, possibly sharply. Nevertheless these Treasury securities will still be overpriced because the major credit agencies will continue to severely overrate the creditworthiness of United States debt. 

 

       As previously stated, had the major credit rating agencies properly rated the mortgage backed securities that financed the overvalued home loans, the housing bubble may have been prevented and the recession avoided. Once the recession began and the finger pointing started the credit agencies took a lot of heat. You would think that taking the blame for a recession that caused both homeowners and stockholders many trillions of dollars would encourage the agencies to reevaluate their criteria for assigning credit ratings. Since two of the three major credit agencies continue to assign their top credit rating to United States debt I can only presume nothing has changed.

 

       Unfortunately politics always plays a roll on major issues unfavorable to someone’s ideology’ On August 5th of 2011 S&P lowered the rating of the sovereign debt of the United Stated from AAA to AA+ with a negative outlook. On August 11th (only 4 days later) a democratic congressional committee decided to investigate S&P on the issue of their downgrade. This may be a factor in why the credit rating agencies continue to overrate U.S. Debt.

 

       The major credit agencies blew it once and now they are blowing it again.

 

 

* * * * * 

 

Uncle Sam: The Honeymoon is over!

 

        Hi, my name is Ralph. My wife Alice and I have been happily married for 25 years. My wife and I love each other very much but we argue almost every day. For reasons unknown to me, my wife thinks I’m irresponsible. I drive a city bus for a living and make a salary of $30,000 a year. I’m pretty much on the low end of the economic scale, but I think big. I’m an idea guy. I am constantly coming up with new ideas to make money. I got some of my best ideas from Ralph Kramden on his old TV series “The Honeymooners” It starred Jackie Gleason, Art Carney, Audrey Meadows and Joyce Randolph.

I borrowed $70,000 to buy a warehouse full of what I call “The Helpful Housewife Happy Handy Kitchen Gadget”. I wisely took out a live TV ad and played the “chef of the future” to advertise it. Sadly, my idea flopped and I lost my entire investment. Never one to give up, I got an inside tip about a movie theater going up. So I borrowed $100,000 and bought a parking lot next door. Unfortunately it turned out to be a drive-in theater. Rats! Now I owe $170,000 that has to be repaid soon. If I can ever get out of debt, I’m thinking about investing in wallpaper that glows in the dark so people can save money on electricity. Will you consider lending me the $170,000 so I can pay off my loan? I admit that I am having a little trouble paying my bills. In fact this year I will need to borrow another $6,400 to make ends meet. If you think I’m a good credit risk please lend it to me. I promise I will pay back every penny, although I have no idea how. Here’s a list of my income and expenses.

 

                                         Income and Expenses for Ralph and Alice

 

                     Expenses                                                             Income

 

           College Tuition           $9,100                                     Salary           $30,000

           Medical Insurance       $9,700                                    New Loan       $6,400

           Private education        $1,100

           Real estate tax           $4,000

           Mortgage payment     $8,200

           Home security               $500

           Transportation            $1,000

           Loan Interest              $2,200

           Other $600

Totals                                  $36,400                                                        $36,400

     Outstanding debt.          $170,000

 

       The bank denied my request citing my poor credit rating and made the following comments on why I would have problems repaying my loan.

       1. I am not living within my means, spending much more than I take in (21%), and I have been doing so for years, thus demonstrating my inability to control my expenses.

       2. 6% to 10% of my income will be needed just to pay interest on my loans.

       3. If I could reduce my expenses by an additional $2,000 a year and use it to pay down my loan, it would take 85 years to complete.

       To put it bluntly, the bank told me my credit rating stinks. Just like Ed Norton said in one of The Honeymooners episodes “the applicant is a bum” When I asked the bank to reconsider the loan and lend me $170,000 for 30 years at a rate under 4%., they responded with a question. What fool would lend money to someone in my financial condition? Certainly the bank was justified in turning down Ralph’s loan request, because there was a huge chance their loan would not get repaid.

I’m sure it’s obvious to the reader that the point I’m getting at is that Ralph’s financial stability and the financial stability of the United States are the same. It’s just a matter of adding zero’s to the numbers and changing the name of some of the expense categories.

 

Comparing Ralphs ad Alice’s Expenses to Uncle Sam’s

 

              Expenses                                                                    Income

 

              (R&A) College Tuition                   $9,100                      Salary                                    $30,000

              (US) Pensions            $910,000,000,000                       Revenues            $3,000,000,000,000

 

              (R&A) Medical Insurance              $9,700                        (R&A) Loan                              $6,400

              (US) Health Care        $970,000,000,000                        (US) Budget Deficit $640,000,000,000

 

              (R&A) Private education               $1,100

              (US) Education           $110,000,000,000

 

              (R&A) Real estate tax                 $4,000

              (US) Welfare             $400,000,000,000

 

              (R&A) Mortgage payment           $8,200

              (US) Defense            $820,000,000,000

 

              (R&A) Home security                    $500

              (US) Protection          $50,000,000,000

 

              (R&A) Transportation                 $1,000

              (US) Transportation $100,000,000,000

 

              (R&A) Loan Interest                   $2,200

              (US) Debt Interest    $220,000,000,000

 

              (R&A) Other                                 $600

              (US) Other                 $60,000,000,000

 

Totals                                          (R&A) $36,400                                                             (R&A) $36,400

                                   (US) $3,640,000,000,000                                             (US) $3,640,000,000,000

 

          R&A = Ralph & Alice                          US = US Government

 

                                                Outstanding debt. (R&A) $170,000

                                                (US)              $17,000,000,000,000

 

       A family of 3 or 4 living on an income of $30,000 a year is a difficult undertaking at best, especially when you realize that the average income for an individual in 2013 was $51,000 and that some families have 2 wage earners. Add to that Ralph’s $170,000 in IOU’s and the need to borrow more to pay his bills. There’s no question that Ralph and Alice have major financial problems.

 

       A town with 1,000 families that was in the same financial situation as the Ralph and Alice would certainly be classified as a poor town. A city with a million similar families or a state with 10 million similar families would both be financial basket cases. Of course this is not the case, as most towns’ cities and states have a mixture of low, middle and high income individuals and families.

 

       The balance sheet of the U.S. Government is a different story altogether. Ralph is a poor credit. His credit rating stinks because his income cannot support his expenses, and his debt locks him into a financial black hole from which it will be next to impossible to escape.

Multiplying Ralph’s income and expenses by 100 or by 1000 will not improve his ability to meet his obligations or improve his credit rating. It’s not the actual numbers that matter, it’s the ratios. If his income increased by 10 times and his expenses and debt are also increased by 10 times you are back to square one. No bank or lending institution will lend Ralph a dime whether his income was $30,000 or $30,000,000 a year with these income and expense ratios.

 

       Like I just stated, multiplying Ralph’s income and expense ratios by 1,000 or 1,000,000 and you do nothing to improve his credit rating, but multiplying it by 100,000,000 and you’re a stellar credit. That’s right! A 5 star credit risk. Credit agencies like Moody’s and Fitch rate your debt as the safest investment on the planet, closely followed by S & P. As shown above, the income, expense and debt ratios of the U.S. Government are exactly the same as Ralph’s, yet investors around the world are willing to lend us trillions of dollars for 30 years at an interest rate of less than 4% and for 10 years at an interest rate of less than 3%.

 

       There are those who would criticize this view because I put Ralph in the same category as the U.S. Government. They would probably point out that the government has taxing powers and laws that guarantee a revenue stream, and they are correct. What the government doesn’t have is the flexibility individuals have in cutting expenses. That is, the government has the opportunity but not the political willpower. Anyway, this argument is not relevant to the issue. The issue is the perception that investors have of the creditworthiness of the United States in spite of its poor balance sheet and huge debt. The major credit agencies perpetuate this fantasy with their top credit ratings. In my opinion, purchasers of U.S. debt will wake up one day and realize that the national debt supports a government whose financial condition is a fantasy and is supported by a house of cards.

 

       When the housing bubble burst around 2008, the major credit agencies were caught off guard. They had given their top AAA rating to many mortgage backed securities which were backed by home loans. They believed that the housing market was shielded from violent price changes. In what now seems like the blink of an eye, the housing bubble burst and on a national level the value of mortgages dropped in value by trillions of dollars. Many AAA rated bonds quickly became junk bonds. The rating agencies had miscalculated the risk in the underlying asset (the home loans). In my opinion they are now repeating this mistake and severely overrating the creditworthiness of the United States and its $17 trillion debt.