A PRECIPITOUS, WRONG, AND DANGEROUS DECISION / THE FINANCIAL TIMES CAPITAL MARKETS ( HIGHLY RECOMMENDED READING )

August 8, 2011 1:59 pm

A precipitous, wrong, and dangerous decision

By Bill Miller

The downgrade by Standard & Poor’s of US sovereign debt, from triple A to double A plus, was precipitous, wrong, and dangerous.


At best, S&P showed a stunning ignorance and disregard for the potential consequences on a fragile global financial system. The rating agency chose to take this action after the worst week in US equity markets since 2008, a week which not only saw stocks fall sharply, but which also witnessed a dangerous escalation in the European debt crisis. The action was wholly unnecessary and the timing could not have been worse. Compounding this, the reasoning was poor, and consequences both short and long term for the global financial system unpredictable.


It is unacceptable that privately-owned, for-profit companies should have special, legally sanctioned status at the heart of the financial system to function as quasi-regulatory authorities whose opinions can determine what securities financial institutions can hold, how much capital they need, what the borrowing costs of every member of the system will be, all based on secret deliberations with no accountability.


The disastrously flawed ratings of these agencies were at the heart of the 2008 financial crisis and S&P’s action threatens to create mayhem again by creating uncertainty about the ability of the US to function in its critical role in the financial system.


There was no need for S&P to rush to judgment just days after a bruising political battle had secured a bipartisan agreement to raise the debt ceiling through the next election cycle and which initiated a process to begin to cut spending and address the nation’s long term fiscal imbalances. Neither Fitch nor Moody’s saw any need to do so, and Moody’s indicated that it saw the agreement as “a turning point in fiscal policy” and declared that a downgrade would be “premature”.


The decision is also wrong. First, it is incredible that S&P should think the US is less creditworthy now than two weeks ago, when an agreement to raise the debt ceiling had not been reached, both parties appeared intransigent, and contingency plans were being considered that included prioritising payments or even declaring the debt ceiling null and void. In any event, an agreement was reached that assures the ability of the US to fund its operations through the next election and initiated a process to tackle the nation’s long standing fiscal imbalances.


The debate on the debt ceiling, moreover, concentrated public attention on the deep fiscal imbalances in the US, and changed the governing priorities to include steps to address the unsustainable trajectory of government spending. Now the debate is centred on if revenue enhancement is needed. This is progress and should have counted for, not against, the triple A rating.


Second, S&P apparently gave little or no weight to the unique role the US plays in the global economy. The US is the world’s largest, most productive economy and the dollar remains the global reserve currency. The only possible alternative, the euro, is structurally flawed and is in what may turn out to be an existential crisis. Issuing its own currency means the US can settle its debts by printing more money if need be, so there is absolutely no question of its ability to pay.

Third, the market says S&P is wrong. The US enjoys among the lowest interest rates in its history coincident with the highest deficits and a daunting long term fiscal outlook. Yet when investors are looking for safe assets, they buy Treasuries. The US is borrowing at lower long term rates than it did when it was running a budget surplus. In the 2008 crisis, investors flocked to Treasuries and the dollar because they sought the safest, most creditworthy assets in the world. S&P seems not to have noticed this.


The agency’s actions pose unpredictable and dangerous risks to the global economy. As Warren Buffett has noted, fear is contagious and spreads quickly; confidence is fragile and only returns gradually and over time. S&P’s actions can only undermine weak confidence and raise uncertainty. It has created what Keynes called irreducible uncertainty. We have no idea of the consequences of S&P deciding the risk-free assets issued by the country that occupies a unique place in the global economy may not be risk free after all.


One consequence we can all hope for is that Congress ends the oligopoly of Nationally Recognised Statistical Ratings Organisations before they contribute to or ignite another financial crisis. Even S&P agrees, stating to its credit that that regulatory reliance on ratings by NRSROs should end. By all means, let’s have S&P, Moodys and Fitch opine about creditworthiness. But let’s have them do it in a free competitive market and not via a legally-sanctioned oligopoly which effectively regulates without oversight or consequence.
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Bill Miller is chief investment officer of Legg Mason Capital Management
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Copyright The Financial Times Limited 2011.