Friday, July 15, 2011

More Ratings Agency Discrediting

Felix Salmon has an interesting chart up today on the rise of AAA debt in the debt markets since 1990 (I've reproduced the chart below, via FT Alphaville). He and FT Alphaville are right to say that it's a scary chart but their conclusions at the end are very wrong.

This chart is at its most terrifying when looking at the runup to the financial crisis from 2002-2006. Securitized debt that was rated AAA exploded into the market and brought about terrifying consequences. However, when Felix looks at the fall of the overall level of AAA-rated debt and its subsequent rise to its highest levels ever (in 2009), and use that to make the assumption that there's now a coming crisis in AAA-rated sovereign debt is a bit far-fetched.

First of all, the rise in the AAA-rated sovereign is a textbook macroeconomic response to a liquidity trap. And most of the rise in AAA-rated sovereign debt is attributable to the United States' stimulus package. If the chart went far enough, I would imagine the bar would be even higher in 2010, though contracting in 2011 and falling to pre-crisis levels completely by 2012-13. So the explosion in sovereign debt is to be expected and it's not an economy-threatening, looming black cloud (And I'd like to make a side-note here to address some of Felix's commenters who think China's to blame for the rise in sovereign debt... there are only 20 countries with AAA ratings and China isn't one of them. Instead it's mostly the United States, Canada, Australia and western European debt we're talking about).

Now, perhaps the rise in sovereign AAA-rated debt would be of concern if those countries were issuing complex and opaque debt instruments or if their political ability to tax and control spending were questionable, but if that were the case, those countries wouldn't have AAA ratings. So we're talking about countries who certainly have the revenue-generating means to pay their debts as well as the ability to pay off debt in their own currencies (for the most part). It's really hard to imagine there's a bubble or a coming problem with the debt issued by these twenty countries (leaving aside the current conservative-fueled, debt-ceiling insanity in the US).

Furthermore, it's arguable that the one thing the ratings agencies rate the most stringently (though incorrectly) is public-sector debt. So it can be assumed that they've been much more stringent in rating the AAA sovereigns than, say, asset-backed securities. This goes without mentioning the fact that sovereign debt ratings reflect public information -- the ratings agencies have no more information about the United States and its ability to pay its debts than you or I. They are simply looking at the political landscape and measuring debt levels to GDP and seeing if there have been defaults in the past.

What critical information are they giving us on sovereign debt that we don't already know? None, basically.

The debts of AAA-rated sovereigns can't really be a coming crisis waiting to happen when textbook macro says current sovereign debt levels are not only necessary, but welcome. Furthermore when countries like the US have successfully run greater debt-to-GDP ratios and higher levels of deficit spending to get out of depressions in the past (without suffering a default or crisis), and when the public and investors have as much information about AAA-rated sovereign debt as the ratings agencies -- what exactly is the fear here?

What really stands out on this chart is not a coming crisis in sovereign debt levels, it's the explosion of AAA-rated securities issued between 1998 and 2008. The size of the AAA-rated securities in the market actually grew to be bigger than the AAA-rated corporate offerings or AAA-rated sovereign debt offerings. Which, logically, is impossible. How can there be more AAA-rated securities floating around, than AAA-rated entities to issue them? The answer to that--natch--is that there can't (although I'll admit that there might be say, a few hundred thousand extremely wealthy individuals who have AAA-rated debt on their mortgages or other loans that could add to this market... but they would have needed to contribute more than a trillion dollars to the overall debt market in 2006).

Anyway, as we all well know, investors were buying AAA-rated debt that wasn't actually AAA (heck, in some cases, the securities weren't even worth the paper they were printed on).

So this chart is really another indictment of the ratings agencies and their collapse into worthlessness, and Felix can be forgiven for not pointing that out (as he's been critical of the agencies before). However, he should revise his opinion of the AAA-sovereign 'problem' and focus more on the distressing fact that the size of the AAA-rated asset-backed securities market didn't shrink to almost nothing 2009. In fact, what that seems to signal that it is still business-as-usual on Wall Street, that nothing's changed, and that since no new measures or regulations have been put in place to fix the ratings system we're going to continue down this path until someone does change it.

After all, the market will always be hungry for AAA-rated debt, so Wall Street and the ratings agencies will dutifully continue to provide the world with the AAA-rated debt it so desperately wants.

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