The triple A crisis – what’s a rating worth anyway

26th July 2011

Yesterday Mindful Money picked up a similar sort of sentiment, from the message boards where commenters felt that treasuries should be avoided but do Salmon's loyal readers all agree? First an excerpt from Salmon's argument.

He asks: "So what happens if the US loses its triple-A? The simple answer is that nobody knows. But it will certainly cause second thoughts among people who up until now have been very good at ignoring the question of credit risk in triple-A assets.

"We believe that our investments are worth whatever they're changing hands for today, even though we're not selling them today, and any state of the world where lots of people wanted to sell those investments is a state of the world where they'd likely be worth much less than they are now.

"The single biggest beneficiary of this suspension of disbelief is the USA. Because everybody believes Treasury bonds to be risk-free. But a world without triple-A debt is a world where investors are more alive to the risks that they're running. And ultimately that's probably a good thing."

TFF doesn't agree and suggests that Salmon is wrong to link treasuries to the previously triple A rated mortgage  backed securities which of course proved to have anything but a low risk.

He writes: "Felix, this proposal smells of a symbolic move more than anything else.

"If there's credit risk in triple-A bonds, it's too small to price or to worry about, and so, by convention, it's ignored."

"All risk is relative. The credit risk for AAA bonds need not be zero, it need only be less than the credit risk for AA bonds. If you truly wanted "zero-risk dollars" (an oxymoron on the face of it), wouldn't you hold physical greenbacks? Or the electronic equivalent on deposit with the Fed? The MBS disaster was another issue entirely. Those bonds were seriously *mis*-rated, and people unquestioningly accepted those ratings. Lazy people, charging millions of dollars for "managing" money that belongs to others."

DwJ is uncertain how the system could be changed. He writes: "If AA+ were the highest rating, would people start thinking of that as risk-free? Would introducing a AAA+ rating and refusing to bestow it on anything stop people from thinking of AAA as risk-free?"

Danny Black, echoing some of the sentiment from yesterday, believes that regulation and even the structure of capitalism is partly to blame though he cannot see how it could be unwound.

He writes: "For some reason you ignored the real reason AAA is so important and that is due to regulation. A significant portion of investors have severe limitations on what they can buy. They are not too lazy or overworked to look at other bonds, they usually cannot buy them hence the tranching and structured products business. For instance UK Pension funds did not think that a notional yield of 3.48% was a great punt for a 50 year gilt but because of the way pension fund liabilities were regulated, magically anyone who bought a 50 year gilt at ANY price who consider more solvent and better funded which reduced the amount the sponsors had to put into the fund. That is a real cash incentive for companies to do something stupid whilst knowing it is stupid.

"The ratings are written into virtually every single derivative contract, again due to regulation. Ratings are written in capital regulation. They are written into most loan covenants. All of which are positive feedback triggers waiting to send a company or country into a death spiral once they hit an arbitrary barrier. Due to their pervasiveness it is hard to see how they could be removed."

Of course it is not all about Treasuries. The Philidelphia Inquirer's Erin Arvedlund, featured here on Seeking Alpha, considers what might happen to municipal bonds, many of which are linked to the US's overall triple A rating.

And a couple of days ago the Wall Street Journal featured an interview with one of those who might downgrade the debt, Standard & Poor's David T. Beers. He told the paper: ""If you want your ratings to do what they are designed to do, you have to call these things as you see them. And that's what we are committed to doing."

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25 thoughts on “The triple A crisis – what’s a rating worth anyway”

  1. JW says:

    Hi Shaun
    I read that some ( 10%) of the Greek Bonds held by hedge funds are written in English Law with far more protection for the holders vis-a vis CDSs. To get a deal the Greeks need unanimity and they are very unlikely to get this group to agree to anything remotely like whats currently on the table.
    On the same lines , most of the later  Portugese bonds are also written under English Law.
    Re the UK debt, there seems to be a lot of misunderstanding about the true nature of this in the MSM. Not surprising given the quite deliberate attempts to obfuscate by governments.

    1. Alex Eames says:

      I still can’t get past the thought that someone mentioned here last week, just before I was going to raise it. Why would anyone who bought any form of credit insurance agree to a haircut? The only reason I can think of is “if they think their insurer is unlikely to pay out”.

      A question on my mind now is “why would anyone purchase government bonds?” (Apart from the banks who have access to “free money”).

      What are the chances of those 30 year Greek bonds being paid back with anything that still has any purchasing power?

      1. JW says:

        Hi Alex
        Apparently one of the hedge funds in the 10% ( those written under English Law) is Elliot Associates a vulture fund who sued the Peruvian government for past interest etc to the tune of over $45bn with a holding of $11bn. They won.
        Highly probable that Greece will default.

    2. Anonymous says:

      Hi JW

      My understanding is that around 40 billion Euros of Greek debt was written under English Law and that these bonds tend to be from the early part of the last decade and before. Roughly when Goldmans got involved actually which makes me wonder….

      However I think that the main issue here is the danger of Collective Action Clauses or CACs which could theoretically be re-written under Greek law at the governments behest, but not under UK law.

      Of course if laws on bonds start to be re-written there will be an even faster dash for the exits for a country that hits trouble.

  2. Anonymous says:

    Nice article, Shaun. I note that Olli Rehn (an anagram of “iron hell”) is quoted as saying he expects a deal on the PSI scheme “to be finalised within a matter of days”. After 7 months of to-ing and fro-ing I am not as “optimistic” as he purports to be!

    1. Anonymous says:

      “iron hell” I haven’t seen that before…

  3. Anonymous says:

    What can’t be repaid won’t be repaid.  I’d imagine that the success of any voluntary writedown would still depend upon an extraordinarily benign economic environment for an extraordinarily long period.

    From what I have read it seems that the threat of a disorderly default doesn’t wash with the hedge funds because they have CDSs written by banks, who would be bailed out if claims on those CDSs were triggered and paid out.

    1. Anonymous says:

      Hi Sean

      As you know I have argued against the importance of CDS’s and note that as far as we can tell the amount of them written on Greek debt has declined. But there are some and hedge funds may hold them.

      I think as we stand we may see some investors hold the March 2012 bond and grit their teeth as I discussed in the article. A kind of Mexican stand-off I guess as they are a lot of different players with different objectives here.

      So even if a PSI deal is proclaimed there could be an ,ahem, moment soon afterwards. Frankly what a mess this is now looking.

  4. Drf says:

    “I will pass that baton over to readers, how temporary do these interventions seem to you?” With regard to UK National Debt, of course “temporary” means permanent and most of it will never be paid back, mainly because there is no way in which the UK government will now receive sufficient revenue to pay much if any of it back, before interest rates are likely to rise.  The cost of servicing the debt, as with all compulsive debtors, will then preclude any possibility of true value repayment. Much of it will thus be “repaid” by further continued debasement of Sterling. In this sense of course it will not be any different to any supposed “Keynesian” stimulus applied many times before  historically by British governments, who have never to my knowledge followed the full cycle of supposed Keynesian stimulus in any of these previous enactments. This is of course because to repay the borrowed stimulus when the economy turns upwards is electoral suicide, since it requires increased taxation and or reduced government spending!  As a result, this is always the half of the supposed Keynesian stimulus cycle which they omit!  They thus use debasement to write off the debt.

    1. outsider says:

      I cannot help feeling that Shaun and yourself are guilty of old thinking here.

       QE at £2 bn per working day can be continued indefinitely so long as real gdp remains below the trend projected by Messrs Brown and Balls in 2003 (or was is 2002?) on the basis of 2.8 per cent growth. No need just to soak up deficits. Buy in all the pre-existing debt too and when that  is exhausted buy up new gilts issued to replace the “notional” gilts that currently fund central government pensions. Once that is achieved the Bank of England can sell its off-balance-sheet QE vehicle to the Treasury for £1. The Government can then cancel out (almost) all the debt to itself, ensuring that it attains a hitherto unheard-of quadruple  A credit rating. Continued inflation will, of course, help in this process but inflation can be controlled by unilaterally raising bank capital requirements pari passu with QE and extending UK stamp duty to all financial transactions, which in turn should limit any risk  of gdp ever reaching the old trend line. This old thinking is so negative.

      1. Anonymous says:

        What happens if the foreign lenders stop financing the UK’s trade deficit ?  Another sterling crisis ?

        1. OwenT says:

          The UK currency is inherently a weak currency by its its very nature.  It needs to be continually propped up by various means and when that all stops it will fall substantially.  Does anyone here advocate stockpiling foreign currency of stronger nations?

          When that scenrio occurs that you mention above, the currency will crash and crash hard.  poor savers and pension funds.

          1. Anonymous says:

            Hi Owen and welcome to my part of the blogosphere

            You pose an interesting idea which is “stockpiling foreign currency of stronger nations”. But I see so many countries with problems or on the other hand currencies which look over-valued so which ones would you buy?

          2. OwenT says:

            Hi Shaun and thanks.  I must admit I do read your blogs regularly and very insightful work indeed.  Those politicians and current crop of  economists could learn alot from reading your blogs – I digress.

            But getting back to which currencies I would buy, I came across a link a while back (wish I still had it) that detailed which countries would still be ‘floating’ if there was a second banking crisis like we saw in 2008 and wouldn’t be totally destroyed by this.  I seem to recall Norway, Sweden, Canada (strange) and a few others from nations which are mostly in surplus with some manufacturing left and/or access to natural resources.
            All currencies are dwindling but to be honest I can’t see this floating exchange-rate system disappearing any time soon.  It’s a good system in my opinion just let down by all the fraud and I’d much prefer it to a gold standard.  What I can see is currencies getting weaker though and the UK sterling seems to be in that category ar atleast that is where it is headed eventually.  So I think holding a range of currencies might be our best bet yet.  Long-term I would say holding any currency other than our native sterling would be a good idea when you hear facts like the UK debt overall being 1000% of GDP.   I can’t see the Central Bank raising interest rates ever from here until this crisis is dealt with globally and even though that would be the one right thing to do right now, it wont – ever, they’ll procastinate until the very end.  Speaking of the end and if it is that sort of an end perhaps we may do away with the current system as unlikely as that is but, going back to hard currency is something that does confound me and in that case gold and other hard assets, as much I’d hate it, for insurance.
            I must admit this is just something that occurred to me and I haven’t actually done any stockpiling yet (it’s not easy wanting to open a bank account in a country where you are not domiciled) but how about yourself, which currencies do you see being strong overal as we move deeper into this economic crisis Shaun?

        2. JW says:

          Hi ExpatinBG
          I think outsider is describing typical MMT vertical money theory. That is keep all the inflationary aspects within the vertical stream, ie between BoE, Treasury and Banks , only letting sufficient out ‘horizontally’ via commercial loans etc to massage the required monetary velocity for planned nominal GDP growth. So over time QE replaces all existing government debt vehicles and liabilities, and the Treasury just writes them off.
          It all hinges on the belief you can control inflation from monetary expansion, usually by taxation, but here outsider is suggesting keeping the ‘money’ in the BoE by increasing capital requirements.
          I have no idea whether this will work in practice, but to a certain extent it does seem to be behind the policies in the Fed, BoE and now the ECB. All advised by the ‘squid’.
          I guess if every CB does it and say China’s yuan follows the dollar in theory the only people to lose out are the ones holding bonds by getting paid in devalued currency. We ( the 99.9%) also hold currency worth 30% less than before ( say), but relatively all the 99.9% of the world is in the same boat.

          1. outsider says:

            Yes. It is amazing how far you can get with logical progression as long as end up with what people want. As you imply, investment banks win mandates and central banks win official friends by devising schemes that logically deliver what their principals (as opposed to principles) want. I have been reminded of this by re-reading David Freud’s memoirs of life at UBS in the 1990s. They even managed to sell Railtrack to City investors on the logic that it was so vehemently opposed by the incoming Labour government that the shares had to be cheap. In the case of QE, the promise of low government borrowing costs underwrites  whatever doubts there might otherwise have been about the economic theory.

            My “logic” even covers ExpatinBG’s point: restrictions on UK banks sterling lending capability to sterilize QE  push business and home-buyers to borrow in foreign currency (as in Hungary), thus sustaining the currency in the short run. Delivering the right answer gives credibility to the logic. Incidentally, sterling fell by a quarter between 2007 and 2009 with a sterling “crisis”. 

             It may, for instance, seem obvious to Anglo-Saxon economists that Greece et al should devalue. But there is no substantive demand within Greece for this to happen, let alone in Italy or Spain, Brussels does not want it, neither do Germany or France. Hence the remorseless logic of austerity. Greeks tend to blame the rich, bondholders and the Germans for their difficulties, not membership of the euro.
            This is not so different from the UK prior to monochrome Wednesday in 1992. There was no clamour to leave the ERM. The Government and Opposition wanted to stay; so did business and even the City, apart from a few mostly growth-minded economists and speculators. The fear was that inflation would soar if the discipline was lost , We only devalued because the Bundesbank refused to support sterling, as it was obliged to do, because the UK was not taking the austerity measures needed to sustain the parity. If Brussels had been able to appoint a compliant UK prime minister, we would have been locked into austerity and semi-depression for years, still convinced that our economic logic was correct.. Plus ca change.    

          2. Anonymous says:

            The idea that we can print away our debt is like alchemy. The lenders will see through such a simplistic scam and find a way to have their pound of flesh.

            I do not regard our current devaluation (roughly 25%) as a sterling crisis. The last sterling crisis in the 70s had 27% inflation and at one point a GBP rate of USD 1.03.  The austerity measures to recover were severe.

            The UK is  a net oil importer, maybe an out price spike wouldn’t do so much damage as the 70s. Also the UK imports food, if you weaken sterling the poor and middle class will need to spend a greater proportion of their incomes on food.

            In regards to Greece, any excuse except saying that the kleptocrat Greek politicians are spending and wasting too much money.

      2. Drf says:

        I cannot help feeling that you are guilty of “new thinking” here; but what you have to learn is that what you mistakenly call old thinking is the basis of all real civilization and the basis of carnal reality. That is how what you and we enjoy at present came into being. Real wealth and real money (sound money) are one and the same. Money is solely a device to avoid the inconvenience of barter. The basis of a successful and stable economy is sound money. Socialism of course does not accept that, because it limits the possibility of imposing sophistic  utopian idiocy on everybody, and as Lenin argued the best manner in which to impose Socialistic destruction on a previously sound economy and civilisation is to use debasement to reorientate the status quo. All neo-Keynesianism and “new” delusional substitutes (inventing new terms to deceive, such as QE) is a devious strategy to implement the original ideas of Lenin, but with the pretence of different objectives. It seems that this is what you also believe is good and will lead to  a successful economic outcome. 

        I completely disagree, and I logically conclude that your stance and that of those who agree with you will only lead to a destruction of real economic stability, and a complete collapse of what we have previously enjoyed as Western Civilisation. If that is what you want then of course you are entitled to your opinion.

        1. outsider says:

          Sorry if my joke was “too clever by half”. As in reply to JW above, I was trying to show how we can all get carried away with our own logic even if our starting point, as with Shaun Richards, is sound. For instance, you can start with a sensible Keynesian view that fiscal policy should be anti-cyclical rather than pro-cyclical (for instance via automatic stabilisers when you have a welfare state) and progress logically to Larry Summers’s ( to me absurd) statement on Reuters today that: “Government has no higher responsibility than insuring (sic) that economies have an adequate level of demand”. 

          1. Alex Eames says:

            “sensible Keynesian”

            Oxymoron alert!!!!!!

  5. Rods says:

    Hi Shaun,

    Another Excellent blog.

    As it looks more and more inevitable that Greece will have to default, I been reading about sovereign defaults and apparently the first recorded default was, yes you’ve guessed it, by Greece in 377BC and she has defaulted 5 times in modern history: 1826, 1843, 1860, 1894 and 1930.

    Hungary has defaulted 7 times since 1918. Spain holds the record having defaulted 13 times since 1476.

    In the 1930’s and again in the 1950’s about 50% (yes, fifty-percent) of recognized sovereign nations defaulted.

    History also shows that there are peaks and troughs with sovereign defaults and inevitably in times of recession / depression or in their aftermath there is a new peak in the number of sovereign defaults.

    I had read that the UK has never defaulted, not true, just never in the modern era, she did 3 times before 1600, the first time in 1340.

    This paper maybe of interest for those interested in a history of sovereign defaults and there is also any interesting section on European currency debasement from 1258 showing it is not a new problem: 

    Shaun in “Your expect the unexpected”, then this history suggests there are going to be quite a few defaults and they won’t be limited to Europe.

    1. Anonymous says:

      Business as usual for Greece et al.

    2. Anonymous says:

      Hi Rods

      Thank you and thanks for the data. These things can become as arguable as football statistics etc. but I remember being told that Sweden hadn’t defaulted and that accordingly she was in a class of one in old era countries….

      For us some have argued that the way Gilts like War Loan were changed was a technical default and some argue that going off the gold standard was a similar event for the US.

  6. Chrisrick says:

    Not sure where I might send these to, but I have a couple of definitions:

    NIC: tax

    fair (as in fair amount of tax): this has a moving definition that when applied to someone rich means ‘more’ and to someone who is not rich means ‘less’.  There is never a consideration that someone who is not rich is still not paying enough tax.  Indeed the definition depends on other ill-defined words such as ‘rich’.

  7. Chrisrick says:

    While I’m at it

    rich (as in rich person): someone with more money than me

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