Monday, July 18, 2011

US debt and credit rating agencies

For a while the debt ceiling standoff has only been at the peripheral of my attention but two recent articles caught my attention.

From WaPo:
The Obama administration has mounted an intense behind-the-scenes campaign to keep the nation’s major credit rating companies from issuing threats that they might downgrade the United States over the swelling size of the federal debt.

Senior administration officials have been trying for months to convince analysts at the credit rating companies — all part of publicly traded firms — that political leaders in Washington can come to an agreement to tame the debt.

The role of ratings agencies in the subprime crisis has escaped scrutiny which is unfortunate since they were more than just a minor player first, by classifying all the toxic securities as AAA and then exacerbating the crisis by turning these “pristine” securities into junk at the first signs of trouble. Lately, they have been major players in the European debt crisis and now the American debt crisis, not by taking a long hard look at their role in creating systemic risks but by trying to reclaim the vestiges of their reputations by trying to appear impartial and objective when downgrading the countries.

It almost appears as though the ratings agencies are trying to shrink the volume of AAA securities. Alphaville reports the following:

… a new report, issued by the BIS and Basel Committee’s joint forum, on the subject of securitisation incentives. ... what it shows has much wider, more current implications.
According to the report, between 1990 and 2006 — the year in which issuance of Asset-Backed Securities (ABS) peaked — assets with the highest credit rating rose from a little over 20 per cent of total rated fixed-income issues to almost 55 per cent. Think about it. More than half of the world’s debt securities were, for all intents and purposes, considered risk-free. In 2006, that was nearly $5,000bn of assets.

The financial crisis had a lot to do with triple-A ratings being slapped on to subprime securities which didn’t warrant them, we know that. The report says between 1990 and 2006 ABS accounted for 64 per cent of the total growth in the amount of AAA-rated fixed income, compared with 27 per cent attributable to the growth in public debt, 2 per cent to corporate and 8 per cent to other products.

But watch what starts happening from 2008 and 2009.

The AAA bubble re-inflates and suddenly sovereign debt becomes the major force driving the world’s triple-A supply. The turmoil of 2008 shunted some investors from ABS into safer sovereign debt, it’s true. But you also had a plethora of incoming bank regulation to purposefully herd investors towards holding more government bonds, plus a glut of central bank liquidity facilities accepting government IOUs as collateral. Where ABS dissipated, sovereign debt stood in to fill the gap. And more.

It’s one reason why the sovereign crisis is well and truly painful.

It’s a global repricing of risk, again, but one that has the potential for a much larger pop, so to speak.

But if U.S. debt is downgraded because they think it should be, where does that leave the other AAA securities? Relative to the downgraded U.S. debt are these securities really still AAA? Think of aggregate shocks and idiosyncratic shocks - is the downgrade of U.S. debt an aggregate shock that affects all securities equally? And then what? Do they all get downgraded too? And will there be any AAA securities left?

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