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S&P's Regulatory Politics
S&P's Regulatory Politics
August 08, 2011
Originally published in The American Spectator
Within 24 hours, the Obama administration went from attacking Standard & Poor's first-ever downgrade of U.S. debt to almost embracing it.
On the Friday night after it was issued, a Treasury department official made public a dispute about an error in which S&P had overstated U.S. liabilities. S&P acknowledged the error, but said it didn't matter in the overall analysis.
Despite the administration's earlier dismay, S&P's statement contained a lot of bones for Democrats to chew on. While not recommending specific tax hikes, S&P griped that "the majority of Republicans in Congress continue to resist any measure that would raise revenues." The report also bemoaned "the prolonged controversy over raising the statutory debt ceiling" and echoed media complaints about the supposed problem of partisan gridlock and divided government.
No wonder that when the White House took over PR from Treasury Department wonks, the government reactions became political. "On Saturday," the Associated Press noted, "the administration appeared to soften its tone." White House press secretary Jay Carney said President Barack Obama believes Washington "must do better" and set aside "our political and ideological differences" in tackling the deficit. Senate Majority Leader Harry Reid gloated that the downgrade "reaffirmed the need for a balanced approach," meaning tax hikes. Then on Sunday, former Obama adviser David Axelrod charged that "this is essentially a tea party downgrade"
While there were some gripes on the Left that noted (correctly) S&P's dismal record at rating mortgage securities, most progressive bloggers and pundits joined Axelrod in sticking to their tried-and-true pastime of blaming the GOP and conservatives. In the coming days, coming weeks, and probably the coming years, look for liberal politicos and the media to use the downgrade and threat of a further one as a bludgeon for higher taxes.
Advocates of limited government, while making the obvious point that the downgrade is in large part a result of uncontrolled federal spending that accelerated massively under the Obama administration, must be careful to keep the focus on restoring economic growth, rather than maintaining a subjective measure of the nation's credit rating. For S&P and the other big rating agencies, long beneficiaries and enablers of big government policies, are experiencing somewhat of a market downgrade themselves.
Given the alternative of Eurozone debt, the doom and gloom scenarios of a U.S. downgrade may be vastly overstated. And even if a lower rating does lower demand for U.S. Treasuries, this may have with the benefit of more investment in the private, as opposed to the government, sector.
Indeed, come Monday, we may find that the markets had already factored in a potential S&P downgrade. S&P was actually a Johnny-come-lately at marking down U.S. debt, as two upstart credit rating agencies, Egan-Jones Rating Co. and Weiss Ratings, had already done so.
Unlike S&P, these firms made clear that their ratings were about long-term prospects, rather than the debt ceiling fight, and emphasized spending over taxes. When Egan-Jones, widely respected for its early downgrades of Bear Stearns and Lehman Brothers , changed its rating of U.S debt from AAA to AA+ on July 16, it explained: "The major factor driving credit quality is the relatively high level of debt and the difficulty in significantly cutting spending. We are taking a negative action not based on the delay in raising the debt ceiling but rather our concern about the high level of debt to GDP."
Similarly, Weiss, which lowered its rating in April from C to C-, offered this explanation: "Our downgrade today is not contingent on the outcome of the debt-ceiling debate."
By contrast, a closer look at the S&P downgrade shows that the firm may have been motivated by its desire to remain a political player. Fox Business correspondent Charlie Gasparino argued on-air Saturday that the firm "boxed itself in" by demanding $4 trillion in cuts and encouraging tax hikes. When Congress passed cuts of less than this amount in a package that contained no tax hikes, S&P likely felt that it had to make good on its threat but do so in a way that curried some favor with the administration in power.
The ratings cartel of S&P, Moody's, and Fitch was created by decades of government regulation blocking meaningful competition. In 1975, the Securities and Exchange Commission (SEC) created the designation of "nationally recognized statistical rating organization" (NRSRO) for credit rating firms. Regulatory agencies soon began requiring that banks, brokerage firms, pensions, and insurance companies carry mandated levels of securities rated AAA from an SEC-approved NRSRO.
From the 1990s until 2003, only the "Big 3" had been approved by the SEC to be NRSROs. And when these firms would rate a new security as AAA, financial firms would rush to buy it to satisfy their regulatory capital requirements. This is what helped created the bubble in AAA-rated mortgage-backed securities.
But slowly and surely, the state-backed financial ratings cartel began to crack. Prodded to increase competition by the bipartisan Credit Rating Agency Reform Act of 2006, there are now ten firms approved by the SEC to be NRSROs, including Egan-Jones. And over the weekend, financial regulators prudently waived the NRSRO requirement so that financial firms holding U.S Treasuries would not have to substitute "safer" bonds of AAA-rated countries such as France to satisfy their regulatory capital requirements.
These developments augur less disastrous results from the downgrade than predicted, and even some positive effects. Interest rates probably won't rise much more than they did when Treasuries were downgraded by Weiss and Egan-Jones. The main reason is that, given events in the European Union, there isn't a safer Treasury bond than the American one to which a "flight to safety" would occur.
As noted in a June 22 analysis by the Financial Times , "With the eurozone engulfed in a debt crisis and emerging market economies, such as China, years away from becoming legitimate global financial entities, investors insist there is really no alternative to the U.S. at the present time." As Jim Paulsen, chief investment strategist at Wells Capital Management, told the paper, "A downgrade for the U.S. would mean the new triple A is double A."
But even if there were slightly higher interest rates and slightly less demand for U.S. bonds as a result of the downgrade, would that really be so bad? After all, this would mean fewer inflationary pressures and higher costs for the government to borrow money to create new bureaucracies.
A more honest evaluation of the risks of government securities also means a more even playing field for entrepreneurs to raise capital. The AAA rating for U.S. and other government securities has given sovereign debt an advantage over private debt. Given the profligate behavior of many of the world's governments, this advantage was often undeserved. If the AAA were gone for the U.S. and European countries, "investors seeking a fixed and totally safe return would no longer look towards governments, but to the most stable and profitable private companies," argues financial analyst Martin Hutchinson at PrudentBear.com
In the meantime, the U.S. should slash spending, taxes, and regulation. Not for the purpose of restoring S&P's AAA rating, but to restore the quadruple-A capitalist system that allowed investors and entrepreneurs to propel America to economic greatness.
Prediction: Defying all conventional "wisdom," the U.S. stock market will be up for the day on Monday. Maybe by 10 points, or maybe 100, but it will end the day in positive territory.