S&P was late, but faster than the others

If anything, Standard & Poor’s downgrading of the U.S. to double-A-plus was overdue and all the rating agencies are showing extraordinary patience with the government.

When I became a sovereign risk analyst 20 years ago, the focus was on emerging market countries with debt denominated in U.S. dollars or other foreign currencies. The measures used to objectively assess risk were external debt to exports and current account positions. There was also a heavy element of subjectivity assessing the political will to adjust economic policies. When Russia defaulted, more attention was focused on the level of interest expense to revenues, but nothing supplemented subjective assessment of political will.

All ratings have some measure of subjectivity. Sovereign ratings have the most subjectivity. Therefore, it is easier to objectively deem a country triple-A, double-A, or single-A than to affix a plus or minus to the rating. My personal method was to say a country that is improving from its current level deserves a plus and a country with a negative trend rates a minus.

Triple-A ratings are indicative of almost nil risk. The U.S. has not been riskless since it started to run large budget deficits when economic growth was above the historic norm in the 2000s. This became apparent when the economic growth associated with that fiscal stimulus resulted in the housing bubble bursting and the financial crisis. So at that point in 2008, you could have said the appropriate rating for the U.S. was double-A, because it was no longer riskless. A double-A rating is an opinion that the risk of default is very, very low – but it is not zero.

The U.S. does not have foreign currency debt, so the only quantitative measure that can be looked at is interest expense to revenue. U.S. interest rates are very low and the rating must incorporate some normalization of rates over time. You also have to estimate future borrowing needs to forecast interest expenses in a model. This is where S&P has come in for some criticism for its $2 trillion difference with the White House. 

However, we are dealing with so much potential variability in the future that this is really not the basis for assigning a double-A rating. The issue is the subjective judgment of whether interest expense to revenues will remain healthy, and there is no consensus in Washington for controlling that ratio.

Washington is deadlocked on two of the drivers of that ratio (revenues and entitlement spending), while the interest expense will be a function of the accumulated debt, inflation, and real economic growth rates. The only certainty is that eventually interest rates will rise and interest expense, as a percentage of current revenues, will increase.

The U.S. does have the benefit of the dollar being a reserve currency and that should raise the rating, but still does not make the country’s debts riskless. With the volatility in the market, you could say reserve-currency status introduces a very big risk if foreign central banks decide to sell their dollars.

Through the years I frequently found myself in disagreement with the rating agencies on these subjective matters. In this case, I find myself agreeing with S&P on the double-A rating and disagreeing on where in the category it belongs, because the political consensus for a prudent mix of revenues and spending over the last 10 years was nonexistent and remains the source of political deadlock. 

I would have taken the U.S. down to double-A-minus, with a stable outlook, reflecting the fact that Washington is starting to talk about things that will control this and voters can change the dynamic in 2012.