Monday, September 30, 2013

Bill Gross and Moody's US Ratings

Last week, Bill Gross sent a tweet suggesting that investors should not trust Moody’s US sovereign rating. Given my own concerns about biases in sovereign ratings generally and a review of recent Moody’s pronouncements on US debt, I think Gross has a valid point.

On July 18, the agency affirmed America’s Aaa rating and raised its outlook from negative to stable. The timing of Moody’s action looks a bit odd in an environment of budget gridlock and threats of default if Congress fails to raise the debt ceiling. In 2011, US credit downgrades were sometimes justified in terms of political dysfunction. Since ongoing deficits will necessitate further debt ceiling hikes in coming years and we continue to face a Cold War style domestic political environment, future drama is all but inevitable. Stable, triple-A sovereigns are not supposed to be a source of drama.

Back on July 13, 2011, Moody’s placed the US rating on review for downgrade “given the rising possibility that the statutory debt limit will not be raised on a timely basis, leading to a default on US Treasury debt obligations.” We are now in the same situation, yet Moody’s has not initiated any sort of review. Worse, on September 11, 2012, Moody’s wrote the following about its plans for the 2013 debt ceiling debate: “the government's rating would likely be placed under review after the debt limit is reached but several weeks before the exhaustion of the Treasury's resources.” This is where we are now, so what happened to the review?

After the 2011 debt ceiling increase, Moody’s affirmed its Aaa rating but assigned a negative outlook to US sovereign credit. It gave four conditions that could trigger an eventual downgrade, one of which was the failure to adopt further fiscal consolidation measures in 2013. No such measures have been adopted this year, nor are any feasible in the current political climate. We did see a resolution to the fiscal cliff debate back in January, but that was not a fiscal consolidation measure. Had nothing been done in January, all of the Bush era tax cuts would have expired. Instead, these cuts were made permanent for 99% of Americans at an estimated ten year cost of $3.6 trillion.

In its September 11, 2012 update, Moody’s conditioned the country’s Aaa rating on the adoption of “specific policies that produce a stabilization and then downward trend in the ratio of federal debt to GDP over the medium term.” In lay terms, Moody’s was asking for a grand bargain which would address taxes and entitlement reform. But, as we all know, there has been no grand bargain nor is it reasonable to expect one until 2015 at the earliest.

Based on Moody’s 2011 and 2012 pronouncements, it is hard to justify the agency’s July 2013 action. Moody’s rationalized it on the grounds that “the US government's debt-to-GDP ratio through 2018 will demonstrate a more pronounced decline than Moody's had anticipated when it assigned the negative outlook”. 

Since Moody’s appears to rely on CBO numbers, it is worth checking this contention against changes in the CBO budget baseline. In August 2011, CBO’s baseline budget projection called for a 65.2% debt to GDP ratio in 2018. The latest CBO forecast estimates a 68.4% ratio in 2018. So things actually look worse in 2018 than originally anticipated, yet Moody’s reaction is an upgraded credit outlook.

So we now see the basis for Bill Gross’ tweet. Moody’s pronouncements on US debt are inconsistent and thus not useful to the investment community. Changes in the rating stance do not appear to have a basis in policy; instead they seem to portray a reluctance to offend the federal government. 

From the perspective of Moody’s shareholders, however, this may be a wise approach: given S&P’s claim that the federal lawsuit it faces was payback for its having downgraded the US debt, Moody’s shareholders may (rightly or wrongly) be fearful that their stock would lose value should Moody’s downgrade the US. Bill Gross may be saying that the presence of such a conflict can undermine any hopes for independence or integrity in the ratings process.

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