The debt downgrade
Someone asked me to reflect on the downgrade of US debt over the weekend. The bottom line is that it is not political.
The rating agencies were established (S & P in 1941) at different points after the Great Depression to give outside opinions on the credit worthiness of various entities, companies, states, municipalities, and bond issuers of all kinds. S &P rates the debt of something like 120 countries around the world. Bonds trade on three bases, the interest rate offered as compared to similar bonds, the length of maturity and the credit worthiness of the issuer. The lower the rating, the higher the interest rate because of the perceived ability, or lack thereof, for the issuer to pay back the loan when the bond matures. ( Will Rogers famous quote is instructive: "I am not so much concerned about the return on my money as the return of my money").
So, highly speculative issuers, smaller companies with questionable financials, or states with deep deficits will be rated lower. Entities with solid financials like blue chip companies will have higher ratings. There were actually only 7 or 8 companies rated AAA last year. I am not sure how many are now.
The rating agencies, Moody's, Fitch and others have been under fire for their falling down on the debt crisis in 2007-8. They appeared to be in bed with the banks and did not give the appropriate downgrades in time to let investors large and small know what was coming. In their defense, many of the bank financials were not transparent and were filled with "off balance sheet" investments. But because US government financials are generally more accessible than private companies were in 2007-8, I believe what we are hearing is more trustworthy. It is interesting that the Obama administration tried to question S & P's assessment, telling them they were off by $2 trillion. It is hard to spin financial reality. S & P responded to them and to Congress this way. "You needed to cut $4 trillion and you only cut $2 trillion...not enough. Thus the downgrade.
The highest and most consistent rating has always been US government bonds which have been rated AAA since S & P began in 1941. They have had this rating because they bear "the full faith and credit of the US government," a virtual iron clad promise to repay the principle on maturity.. We have never defaulted on these bonds. US Agency bonds, Farm Credit, TVA, Fannie Mae and Freddie Mac have normally carried "implicit" though not "explicit" guarantees to repay.
It is a good thing that S & P did what they did because it takes the debt fight out of the political realm and makes it purely financial. It is like a teenager who is late on his car insurance bill who comes home with all kinds of excuses about why he hasn't paid it. His father responds, "I don't care why. If you don't pay this, you can't drive anymore." S & P said to the federal government, "It's up to you to fix this and what you did last week didn't fix it."
The bad news is that all interest rates from home mortgages to car loans will rise slightly. Canada lost their AAA rating in 1994 but they cut spending and got it back in 1997. It will probably take us longer. What this mandates now is action. The time for talk is over.
Jay Haug is a former financial advisor and free lance writer living in Ponte Vedra Beach, Florida. You may e-mail him at email@example.com