On Saturday it will be one year since Standard & Poor's cut America's credit rating from AAA to AA+, the first ratings cut in U.S. history.
Did the downgrade matter? Not judging by the yield on the 10-year Treasury note, which has slid to 1.48% from 2.32% a year ago, a 36% drop. It stands to reason that yields would go up when a big bond rater raises red flags about the creditworthiness of the world's largest economy, but that didn't happen here. Meanwhile, the S&P 500 has risen 22% in the past 12 months. Some alarm bells.
Low Treasury yields suggest the market still wants to buy the U.S., and that S&P's downgrade was, at the end of the day, a non-event for the financial markets. An important caveat that can't be ignored: The Federal Reserve has spent billions of dollars on Treasury debt in order to keep rates depressed. That's the type of virtually unlimited spending power that tends to elevate prices and lessen yields, as well as send return-seeking investors into equities.
The downgrade for the U.S. is the most prominent call any of us has seen, but other rating actions have captured headlines recently. In June, Moody's lowered its ratings on a group of the world's biggest banks, and late last month, the firm changed its outlook on Germany, the Netherlands and Luxembourg to negative from stable. Germany did have a slight uptick in yields after the downward shift in opinion, but it quickly stabilized. What would account for that?
"They're still the best credit [in Europe]," says John Armstrong, a portfolio manager and senior fixed-income strategist at Burke Lawton Brewer & Burke Investment Management in Ambler, Pa. "They are still the safe haven." Yields now have come up 20 basis points on the German 10-year since the Moody's report on July 23, but at 1.23%, they're more than 100 basis points below where they stood a year ago, FactSet data show.
As was the case with the U.S. a year ago, the biggest economy in Europe seems to be shaking off rating agency worries, seemingly two clear signs of their waning influence. But hang on. Rating actions such as these "don't really affect the bellwether issuers, like the U.S. or Germany," Armstrong says. The impact, he explains, is instead more pronounced in the peripheral countries, like Spain.
Armstrong describes Moody's outlook change as a "proactive measure" that should tell Europe it's going in the wrong direction. In fact, he sees it as a positive for the strongest member of the euro zone. "Now Germany has a reason for calling for balance," he says. "Germany has political help and can say 'we can't do this ourselves'."
Turns out it might not have to. Only days after the Moody's report, European Central Bank President Mario Draghi said the ECB would "do whatever it takes to preserve the euro." Those remarks were meant to calm market fears about the unstable nations, notably Italy and Spain, where yields have risen to unsettling levels, and taken to mean direct bond purchases could be on the horizon. On Thursday, the ECB didn't take specific action, but said it would look into buying bonds.
The problem is that, whether in the United States or Europe, multiple rounds of extraordinary taxpayer support and central bank action can't go on interminably without credit quality being questioned. Then again, there's an argument that the true solution isn't always harsh austerity measures to control spending. The EU, more so than the U.S., has got to get control of its economy, and for more than two years its policy steps have done next to nothing to end both the specific and the nebulous "worries about Europe". Maybe another well-placed downgrade or two would succeed in getting the point across, though S&P this week did maintain its stable outlook on German debt.
That the U.S. is probably healthier than Europe isn't saying much, mind you. "If you asked if the U.S. balance sheet is worse than it was three or four years ago, you would say yes," says Jason Brady, a fixed-income portfolio manager at Thornburg Investment Management in Santa Fe, N.M., and the author of Income Investing with Bonds, Stocks and Money Markets.
Last August, when S&P cut its U.S. rating, it was applauded by some, reviled by others. In taking the action, the agency said that a fiscal agreement between Congress and the White House didn't go far enough to qualify as a solid plan. Further justification for the downgrade came with concerns about "the effectiveness, stability and predictability of American policymaking and political institutions," and uncertainty with regard to "bridging the gulf between the political parties over fiscal policy."
That was a year ago. If you can name anything substantial that's changed since then, raise your hand. Here's something: In 2012, we've got the fiscal cliff.
Issues of Trust
While the concept of a downgrade laying the groundwork for an economic coming-together is a stretch, conversations with bond market professionals and agency representatives make at least a couple of things clear -- ratings are definitely used as part of forming a detailed perspective on a given debt issuer and its securities, but they're only one piece among many that go into a credit analysis.
Brady says money managers and professional investors have to do their own research, and while the agencies are another set of eyes, he wouldn't ever rely on them in isolation. That said, they are a part of his work. "[Ratings are] effectively an assurance to the investor that I'm not going to say, 'This stuff stinks. I'm going to go buy triple-C," he says.
Not every market participant would necessarily want it this way. A recent Bloomberg report contended that some of the world's biggest investors don't trust the agencies. "They're there because people have to have them, not because people believe in them," former S&P employee David Jacob was quoted as saying in the article.
The "have to have them" part is central to understanding the role the agencies still have in the market, and not in the theoretical sense. Credit ratings have no small part in ensuring an issuer can sell new debt, and for a fixed-income portfolio manager, the ratings influence the securities that can be owned.
For instance, without a high-enough rating, investment-grade fixed-income mutual funds would be prohibited from buying a given debt instrument. If the fund were to own a bond that lost its investment-grade rating, that bond would have to be sold, likely driving the price down and the yield, which moves in the opposite direction, up. The lowest investment-grade ratings are Baa3 at Moody's and BBB- at S&P and Fitch.
So that represents a practical application of when and how the agencies matter. Where problems can arise, Brady says, is when an entire asset class gets wrongly rated: "I think the five most dangerous words in bond investing are, 'It's cheap for the rating.'"
Subprime and CDOs
When regular Americans hear about the agencies, they might bristle. Immediately springing to mind is the model that has debt issuers pay agencies to put ratings on their bonds. That's often seen as an inherent conflict of interest.
Then there's that issue of the top ratings that were assigned to a multitude of subprime and less-than-pristine housing-related debt securities in the early- and mid-2000s. That's one of the factors often blamed for allowing the housing market to stay overheated for as long as it did, the ultimate collapse of which contributed heavily to the severe U.S. recession.
Let's adjust the question of "mattering" for a moment and look at just how influential the agencies are. Daniel Noonan, a spokesman with Fitch Ratings in New York, says it's not uncommon for this to be answered with extremes. "Some critics say the rating agencies are too influential, and others say we are irrelevant," he says. "Clearly, we can't be both."
A Senate report in the spring of last year, called Wall Street and the Financial Crisis: Anatomy of a Financial Collapse, blistered the two largest U.S. agencies, Moody's and S&P, for their place in the credit market meltdown. The duo issued their best ratings on a variety of residential mortgage-backed securities (RMBS) and collateralized debt obligations (CDOs), making them "seem like safe investments" and helping to create a market for them, the report said. Then, in mid-2007, the firms began to downgrade the instruments, a move that "perhaps more than any other single event triggered the financial crisis," according to the report.
Stop reading there, and you won't get the full story. The report does shine an extremely bright light on numerous instances of bad behavior and a system that was in need of reform, but it still recognizes the importance of the agencies' continued existence and operation in the credit markets -- though it did make a series of recommendations about their place in the future.
Among them were to have the Securities and Exchange Commission rank the agencies on their performance, give investors the ability to file civil lawsuits against the raters for wrongly inflated debt grades and the idea that the federal government's reliance on privately issued ratings should be reduced.
Moody's and S&P both have documentation on their websites describing some of the changes they've made to their practices since the credit crunch. For details on the changes made by S&P, go here. To read up on Moody's changes, click here.
While Noonan says he understands the criticism the agencies have faced, the industry has gotten a "tighter focus" on the way ratings are used in the years since the financial crisis. "In some parts of the market, over-reliance on ratings became a real problem," he says. "The crisis forced the ratings agencies to take a good hard look at themselves."
Ultimately, it's easy to dismiss the rating agencies, to say they're incapable of impartiality, that they don't matter and can't be trusted. What's much harder to say, but necessary to acknowledge, is that the system of debt ratings is so entrenched in the U.S. and around the world that unwinding it or even making significant change would be a gargantuan task.
Ratings do matter, they are part of the market fabric, and they can affect the securities you own. But they're opinions on creditworthiness, not on where prices and yields should or will be.
If the agencies can succeed in getting governments to think in new and better ways about really fixing economies, we should hope they don't let up.