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Dear S&P, Moody’s, and Fitch,
You are the world’s three dominant rating agencies, largely controlling the ratings of bonds and debts issued by thousands of corporations, municipalities, and sovereign governments.
I am the chairman of Weiss Ratings, an independent rating agency. (See Weiss Ratings’ press release on MarketWatch or “Weiss Is Returning to Ratings Business” in the Wall Street Journal.)
And today, I challenge you to promptly take the bold action that you have so far avoided — to downgrade the long-term credit rating of the U.S. government in order to help protect investors and prod Washington to fix its finances.
The necessary first step toward solving our nation’s financial problems is to recognize and confront them honestly. But based on the myriad of risk factors impacting U.S. government debt, which I summarize below, the U.S. government’s triple-A rating is an anachronism that is based largely on hope and fiction.
More than ever before — especially in light of your ratings missteps of recent years — you now have the opportunity to rise to the occasion and warn investors of the true risks they face:
Now is your best chance to proactively downgrade Treasury notes and bonds, TIPS, Ginnie Maes, and all other long-term debts issued by government-run entities.
Needless to say, the downgrade would be historic, pressuring Treasury bond prices lower and adding upward pressure to long-term interest rates. And undoubtedly, as we’ve seen in response to your recent downgrades of euro-zone countries, backlash from government officials is to be expected.
But as history has proven repeatedly, the consequences of procrastination can be far more serious:
First, without the proper warnings, you help entice millions of hard-working citizens, retirees, and their intermediaries to pour trillions more into a potential debt trap … or at best, to be severely underpaid for the actual risks they are taking.
Second, without the appropriate downgrade, you give policymakers a green light to perpetuate their fiscal follies, further degrading our government’s ability to meet future obligations.
Worst of all, by continuing to reaffirm America’s triple-A rating, you help create a false sense of security overall — the recipe for a possible meltdown in the market for U.S. sovereign debts.
In the past, you have often hesitated to downgrade large institutions with deteriorating finances. Please, do not repeat that error. If you do, history shows that it can end in disaster, as illustrated by the following four case studies:
Case Study 1
Major Life and Health Insurance
Companies Failures of the Early 1990s
In its landmark 1994 study of rating agencies, the Government Accountability Office (GAO) concluded that you did not downgrade large insurance companies, which subsequently failed, until it was too late for most policyholders:
S&P did not issue a “vulnerable” rating for one of the biggest failed companies, Fidelity Banker’s Life, until six days before the failure; and for another, Monarch Life, until 351 days after the failure.
Moody’s, to its credit, was the first to warn about the failure of Executive Life of California. However, it did not issue a “vulnerable” rating on Mutual Benefit Life, the largest insurance company failure, until two days after its demise.
In the same study, the GAO demonstrated that the nation’s largest insurance rating agency, A.M. Best, also failed to protect the public. Best did not issue a “vulnerable” rating on Executive Life of New York until the day after it failed; on Fidelity Bankers Life, until two days after it failed; on Mutual Benefit Life, until three days after it failed; and on First Capital Life, until five days after it failed. Moreover, for Monarch Life, Best never issued a “vulnerable” rating, instead assigning a non-published rating four days after the company failed.
In the final tally, over six million U.S. policyholders were caught in insurance company failures for which they received little or no warning from established rating agencies.
Case Study 2
Enron Failure of 2001
The New York Times reported that you saw signs of Enron’s deteriorating finances in May 2001, but did little to warn investors until at least five months later. Unfortunately, however, that was long after more problems had emerged and Enron’s slide into bankruptcy had accelerated. (See “Credit Agencies Waited Months To Voice Doubt About Enron.”)
At the time, you claimed you had no way of knowing about the company’s internal shenanigans. But you also admitted that, well before the general public suspected wrongdoing at Enron, you were aware of at least one of the critical factors in the failure — that trusts related to Enron had made financial commitments which were tied to Enron’s own stock price. How did you know? Because you rated the bonds and notes sold by those same trusts.
Nevertheless, it wasn’t until November 28, just days before Enron filed for Chapter 11, that you first lowered its debt ratings below investment grade.
Case Study 3
Mortgage Meltdown of 2007-2008
Congress, regulators, investors, and some of your former executives generally agree that your triple-A ratings on mortgage-backed securities grossly overestimated their credit quality; that this played a pivotal role in the debt crisis; and that the primary factor behind your inflated ratings were multiple conflicts of interest between you and the issuers:
Conflict #1. As with nearly all other ratings you issue, your mortgage security ratings were paid for by the issuers, empowering them to achieve undue influence over the ratings process.
Conflict #2. You earned substantial additional consulting fees to help structure the very securities you rated.
Conflict #3. You revealed your ratings formulas to issuers, helping them manipulate their data to game the system and more easily get high grades for their junk securities.
These conflicts help explain why:
- Senator Al Franken has now won bipartisan support for a proposal to do away with your three-way oligopoly of the credit ratings industry. (See Reuters story posted Friday by John Parry, “U.S. amendment could curb rating agencies’ power.”)
- Manhattan federal Judge Scheindlin recently denied your motion to dismiss a class-action lawsuit against you claiming fraud — filed by King County, Washington, and Iowa Student Loan Liquidity Corporation (“For Big Rating Agencies, the Blows Keep On Comin’.”)
- And a California state court has just decided to let the California Public Employees’ Retirement System go forward with its $1 billion lawsuit against you claiming negligent misrepresentation (“Calpers Case Against Ratings Agencies Can Go Forward.”).
Case Study 4
Major Investment Bank Failures
In 2008-2009 Debt Crisis
When major Wall Street firms suffered deteriorating finances, you could have played a role in warning the public of those failures. Instead, it appears you chose not to:
- Bear Stearns failure: On the day of the failure, March 14, 2008, Moody’s maintained a rating for Bear Stearns of A2, the same rating it had published from June 1995 through June 2003; S&P was equally generous, giving the firm an A rating until the day of failure; and Fitch had assigned Bear Stearns an A+ rating throughout the 18-year period between February 2, 1990 the failure date.
- Lehman Brothers failure: On the morning of the failure, Moody’s still gave Lehman Brothers a rating of A2; S&P gave it an A; and Fitch gave it an A+.
- We witnessed a similar pattern of complacency with the failures of New Century Financial, which filed for Chapter 11 bankruptcy in 2007; Countrywide Financial, which was bought out by Bank of America in 2008; Washington Mutual, which filed for bankruptcy in September of that year; and Wachovia Bank, which was acquired by Wells Fargo by year-end 2008.
The Consequences of Complacency
Can Be Catastrophic
In nearly all the failures I’ve cited above, publicly available data made the risks evident well in advance. (See Weiss Ratings study.)
But in virtually every case, rather than protect investors from issuer defaults, your priority seems to have been to shield issuers from investor selling.
And in nearly every case, we now know how catastrophic the consequences have been for investors, for the economy and, ultimately, even for the issuers themselves.
Indeed, if you had not shielded issuers from public scrutiny and selling pressure, they might have acted sooner to bolster their balance sheets. At a minimum, if you had released prompter, incremental downgrades, you could have given investors the chance to absorb the bad news in smaller doses, helping to avoid much of the shock and panic that ultimately prevailed.
This is why it’s so vital that you downgrade U.S. government debt now.
Factors Warranting an Immediate Downgrade
Of Long-Term U.S. Government Debt
The risk factors justify nothing less:
1. Debts and deficits. You have recently downgraded sovereign nations with deficit and debt ratios that are equivalent — or even superior — to those of the United States. Specifically,
- S&P downgraded Spain’s long-term credit rating on April 28 to AA with a negative outlook, due, in part, to its government debts totaling 59.2 percent of GDP. In contrast, the United States government and its agencies have total debts equal to 94.7 percent of GDP, or nearly 60 percent more than Spain’s.
- S&P downgraded Portugal’s long-term credit rating on April 27 by two notches, from A+ to A-, citing the risk of a further downgrade should fiscal consolidation fall short of expectations or should concerns over government liquidity mount. However, in proportion to its economy, Portugal’s current federal deficit is actually smaller than ours — 8.3 percent of GDP compared to the U.S. deficit at 10.6 percent of GDP.
- Greece, at the heart of the crisis, has been downgraded by all three rating agencies. But even compared to Greece, America’s deficit/GDP level is only slightly less bad — 10.6 percent in the U.S. vs. 12.2 percent in Greece.
Of course, there are other factors that have prompted you to downgrade these euro-zone countries — such as panic in their financial markets, a sudden disappearance of liquidity for their bonds, and the surging cost of raising new funds. But it is simply not reasonable to wait for a similar disaster in U.S. government bond markets before downgrading America’s long-term debt.
2. Outdated arguments. It appears that you are making special allowances for U.S. debt because of America’s size and stature in the global financial system. However, that argument is largely outdated.
Given the greater role played by bailouts since the debt crisis of 2008, it is the smaller nations that may now have a strategic advantage: They can usually count on emergency external financing from richer nations or the International Monetary Fund. The United States cannot. There’s simply no other country big enough to bail it out.
3. Vulnerability to capital flight. The United States is the world’s largest debtor nation, owing far more to foreign creditors than any other country, leaving the U.S. vulnerable to capital flight. Yes, the U.S. has a unique advantage — because the dollar is the world’s primary reserve currency. But that’s a double-edge sword: It also helps ensnare the U.S. into more foreign debts, raising still further America’s vulnerability level.
4. Aggressive central bank action. Among all major central banks, the U.S. Federal Reserve has been the most aggressive in buying up low-quality debt, more than doubling the size of America’s monetary base in just 18 months. This alone should raise serious questions about the underlying stability of U.S. financial institutions, the sustainability of the U.S. economic recovery, and the long-term ability of the U.S. Treasury to fund and repay its debts. (See “Bernanke Running Amuck.”)
More Threats to America’s
Long-Term Credit
All told, as proposed by Grant’s Interest Rate Observer, and as summarized here last month in “14 Risks With Supposedly ‘Safest’ Securities,” there are many risk factors which you must consider when evaluating America’s long-term credit rating. These include:
- The U.S. government is now exposed to trillions of dollars in contingent liabilities from its intervention on behalf of financial institutions during the 2008-2009 debt crisis.
- Mandatory outlays for retirement insurance and health care are expected to increase substantially in future years, with the present value of future expenditures estimated by the Treasury Department at $46 trillion.
- The U.S. Federal Reserve, as part of its response to the financial crisis, may be exposed to significant credit risk.
- The U.S. economy is heavily indebted at all levels, despite recent deleveraging.
- U.S. states and municipalities are experiencing severe economic distress and may require intervention from the federal government.
- Elected officials may not take the necessary steps to ensure long-term debt sustainability and may take actions counter to the interests of bondholders.
- The U.S. dollar may not continue to enjoy reserve currency status and may decline in the future.
- A rise in interest rates could adversely affect government finances.
- Improper payments by the federal government continue to increase despite the Improper Payments Information Act of 2002.
- The U.S. government has failed its official audit by the Government Accountability Office (GAO) for 13 years in a row, with 38 material weaknesses found in 24 government departments and agencies.
The case for a U.S. debt downgrade is overwhelming. I challenge you to take the appropriate action. Any failure to do so can only enhance the risk of another financial meltdown for which no bailout would be possible.
Sincerely,
Martin D. Weiss, Ph.D.
Chairman and Founder, Weiss Ratings
About Money and Markets
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