Credit Ratings Firms and Market Stability

Once again, a credit agency is at the center of a market maelstrom.

This time it was Standard & Poor’s (S&P) with its downgrade of the U.S. sovereign debt rating by one notch from AAA to AA+ with a negative outlook.

So far, neither Fitch Inc. nor Moody’s Investors Service Inc. have downgraded the U.S. sovereign rating. Fitch is in the process of reviewing the U.S. sovereign rating and will provide its opinion by the end of August.

Fitch states on its website that “as it expected, agreement was reached on an increase in the United States’ debt ceiling and, commensurate with its ‘AAA’ rating, the risk of sovereign default remains extremely low.”

Moody’s Investors Service retained its Aaa rating for the U.S. sovereign debt, but placed it on a negative outlook, which puts the United States on notice for a possible future downgrade.

“In assigning a negative outlook to the rating, Moody’s indicated, however, that there would be a risk of downgrade,” according to Moody’s press release. Four reasons were given for a possible downgrade, including rising borrowing costs and a worsening economic outlook.

Experts suggest that if the S&P downgrade spurs the U.S. political establishment into action instead of political game playing, the downgrade will be of short duration. Though, historically, once a country was downgraded, it took years before it went back up again.

Years ago, Australia, Canada, Denmark, Finland, and Sweden lost their AAA ratings. It took between 9 and 18 years before these countries got the AAA rating back.

Australia, Austria, Canada, Denmark, Finland, France, Germany, Netherlands, Norway, Singapore, Sweden, Switzerland, and the United Kingdom are still in the AAA club; so are Guernsey, Isle of Man, and Liechtenstein.

Biting the Hand That Feeds You

“Standard & Poor’s—a private company—designated, but not regulated by the Securities and Exchange Commission of the United States as a Nationally Recognized Statistical Rating Agency (NRSRO)—downgraded the government that provides the rating agency with its entire franchise. Perhaps the most incredible example of biting the hand that feeds you ever seen in financial history,” said Dan Alpert, founding managing partner of investment firm Westwood Capital, in a blog on The Big Picture website.

Predicting the outcome of the S&P action is difficult. But, if the S&P action results in economic hardship for the United States and interest rate hikes cause the United States problems in repaying its debt, this rating agency would be in part responsible for a deterioration of the U.S. fiscal situation.

“It’s being argued that yesterday’s downgrade of the credit rating of the United States government by Standard and Poor’s could increase borrowing costs throughout the economy, worsen the burden of debt, retard a recovery that already appears to be faltering, affect political brinkmanship in future negotiations, and further tarnish our national reputation,” wrote Rajiv Sethi, professor at Columbia University, in an Aug. 6 article on his blog.

Economist Paul Krugman took note and called the S&P action traitorous. As a case in point, he pointed to the U.S. 10-year interest rate of 2.77 percent on Aug. 8, which has been below $3 since the end of July 2010. He noted that investors are still pumping their funds into U.S. debt, suggesting that this is enough to show what the market thinks of the safety of investments in the United States.

“In today’s global economy, however, the U.S. credit rating downgrade may prove catastrophic,” spotlights a recent article on the Heritage Foundation website.

Alpert views the S&P action as an act of a spoiled child who has taken on a task for which it is not qualified or equipped to handle. He reasons that there is no doubt that the United States would never default on its obligation, and the wealth in the United States is such that the entire debt could be paid, including interest, if all the country’s citizens’ wealth were to be put into one pot.

“Moreover, as the ‘owner of the printing press’ of the world’s reserve currency, the U.S. has ample ability to monetize its own debt pretty much any time it chooses. And, in fact, the country has been doing just that during years of quantitative easing policy,” argues Alpert in his article.

Downgrade Precipitates Market Unrest

“There’s no way around it: stocks are set to start the week with startling losses, as traders spent the weekend digesting Friday’s devastating ratings downgrade by S&P,” according to an Aug. 8 article on the NASDAQ website.

On the morning of Aug. 8, the first day of trading after the U.S. downgrade, the Dow Jones Industrial Average dropped by 2.97 percent by 10:41 a.m. and was down 5.55 percent at the close of trading. At closing, the NASDAQ 100 had dropped by 6.11 percent, the S&P 500 by 6.66 percent, and the American Stock Exchange Composite Index was moving downward and had dropped by 6.32 percent.

The 30-year Treasury Bond Index plunged by 2.48 percent during morning trading on Aug. 8 and was at 2.40 percent at close, when compared to 2.77 percent on Aug. 1.

The only upward trend could be seen in the CBOE Gold Index, which rose by 1.01 percent midmorning on Aug. 8. The CBOE gold index tracks stock prices of firms active in the mining and production of gold.

By close on Aug. 8, gold per ounce had gone up by $53.80 to $1,718.20, a 3.23 percent increase, and silver went up by 1.85 percent to $39.13 per ounce, according to the KITCO website. On the other hand, platinum (-0.17 percent) and palladium (-3.77 percent) did not share the same good fortune of gold and silver.

Stocks of firms in the financial sector with heavy exposure to U.S. Treasuries plummeted. By closing on Aug. 8, Citigroup Inc.’s stock had dropped from $33.44 on Aug. 5 to $27.95, sliding down 16.42 percent. During the same time interval, JPMorgan Chase & Co. dropped from $37.60 to $34.06.

“The world equity markets were under significant duress today [Aug. 8]. The selloff started overnight in Asia, shifted to Europe in the early morning hours, and then continued on these shores [United States] right through to the closing bell, with merely a glimpse of abortive bargain hunting taking place from time to time during the session.

“A plethora of negative news—punctuated by last Friday’s [Aug. 5] first-ever credit ratings downgrade for U.S.-backed debt from one of the major ratings agencies—continues to drive investors away from equities,” according to an Aug. 8 article on the Value Line website, an investment research firm.

Next…Limiting Profitability of Credit Agencies