From our vault: Who is Standard & Poor's and why is it so powerful?
- Sipho Hlongwane
- 21 Apr 2011 07:41 (South Africa)
US Federal Reserve chairman Ben Bernanke’s all-or-nothing fiscal plan came under serious question on Monday when the Big Three rating agency Standards & Poor’s downgraded its outlook on US sovereign debt to “negative”. But will the new S&P outlook cause a sudden outbreak of accord on Capitol Hill on how to tackle the mounting budget deficit? And why is the S&P’s wish Wall Street’s command? Who is S&P anyway? By SIPHO HLONGWANE.
For many years, things have not been amicable in the US government. Fresh from a fisticuff over the budget that saw the government come tantalisingly close to a shutdown, the Democrats and Republicans are failing to find common ground on how to tackle the budget deficit.
But the news from ratings agency Standard & Poor’s, who downgraded their outlook on America’s sovereign debt from “stable” to “negative” may force a rethink on this budget deficit fight. S&P’s new outlook means there is now a one-in-three chance they may downgrade America’s AAA credit rating within two years.
Bloomberg said on Monday, “S&P reaffirmed the US government credit rating at the highest level, but said that it could lower the rating in the future if budget deficits aren't brought under control.”
Speaking on Bloomberg TV, David Beers, S&P's global head of sovereign and international public finance ratings said that outlook was a result of the administration and congress failing to reach an agreement on a big and credible enough plan to reduce the deficit.
Mohammad Al-Arian, the head of Pimco, the world’s largest bond fund, warned that the risk of the US losing its stellar credit rating would mean a weaker dollar, higher borrowing costs for all Americans and less willingness from other currencies to hold US dollars. Pimco recently sold all its US bond holdings, according to Bloomberg TV.
Analysts are in agreement the lower outlook is meant to tell the US government the budget deficit cannot remain as it is. As of 25 March 2011, the deficit was $14.26 trillion, or 93.7% of US GDP for 2010. The debt is the highest it has ever been in terms of how much exactly the US owes, but as a percentage of annual GDP it was a lot higher during WWII. That is unlikely to ease anyone’s mind.
Not all is lost just yet, according to Vestact market analyst Byron Lotter. “This is an outlook on what is going to happen. Remember that this just means there is a 33% chance of a downgrade,” Lotter said in a telephonic interview with The Daily Maverick. “People are saying cracks are starting to appear in the Fed’s quantitative easing plan. The US has pumped lots of money into this policy, which they hope will increase spending meaning the government can get more tax from companies and that will take care of the deficit.
“The new S&P outlook is sending shudders through the market because the Fed’s plan is all-or-nothing. If it doesn’t work, then they don’t really have anything else to fall back on,” said Lotter.
Lotter said the Wall Street sell was a symptom of what he called the “sell first and do the research later” instinct of the market. His own feeling was that cheap money and innovation would pull the US economy through the doldrums that it currently is in.
The doldrums in question is the global economic downturn caused by the subprime mortgage meltdown in US markets, of course, and S&P was accused by a New York attorney of having a hand in the crisis. Andrew Cuomo (then New York’s attorney general) wanted an investigation into the relationship between rating agencies like S&P and Moody’s and Wall Street firms. The NYT said in 2008 , “Cuomo’s office is looking into how the ratings agencies assigned top triple-A ratings to many bonds backed by risky subprime home loans. He wants to know if the firms asked for and received information that would have warned them about specific risks associated with home mortgages. Cuomo’s office has not filed any charges against the ratings firms.”
The ratings agencies eventually reached a settlement with Cuomo, agreeing to modify practices to avoid sanctions and not to be made to admit wrongdoing.
The Securities and Exchange Commission, which has had a busy 30-or-so months, also made much noise about looking into the affairs of S&P, citing the incestuous relationship between ratings agencies and Wall Street firms (you pay someone like S&P or Moody’s to rate your company or financial product) which may or may not have caused these agencies to be unduly optimistic about the collateralised debt obligations that were fashionable in the bull markets of the last decade.
There seemed to be a perception back in 2008, amid their reforms, that ratings agencies’ trustworthiness had taken a big knock as a result of having failed to foresee the market crash. The reaction of the markets and the US government on Monday and Tuesday would suggest they still take S&P opinion seriously. In the deal struck between Cuomo and the New York ratings agencies, their powers weren’t stripped as such (since that power is driven largely by perception) but the incentives were changed. Bond issuers would now pay for any preliminary work reviewing the structure of US subprime-mortgage securities as well as issuing a rating on the debt, instead of paying the companies they select to rate. This new law is supposed to reduce the incentives for a positive rating and seeks to do so by tilting the balance of power (and make no mistake, money is power in these streets) towards the ratings agencies.
Perhaps the single masterstroke of S&P is of course the S&P 500, a free-float capitalisation-weighted index that is a cap of 500 large-cap securities traded on the New York Stock Exchange and Nasdaq. The index is nearly 50 years old and is the second-most followed index (after the Dow Jones Industrial Average) of large-cap US stocks. In fact, most funds match their progress against the S&P 500. Quite simply, the S&P 500 is Wall Street’s licked finger held aloft in the still air, looking for the next direction in which the wind will blow. That is how S&P is more powerful than the US government – when it comes to Wall Street (the cold, yet beating heart of the American economy), nobody holds greater sway.
The history of the company began in 1860 when Henry Varnum Poor published a tome called “History of the Railroads and Canals of the United States”. Construction in the railroad industry had ushered in the era of private capital markets, but there was precious little information on companies and the industry. Poor’s book catalogued that information. In 1941 the company merged with Standard Statistics (which had focused on markets outside of the railroads) to form S&P. The S&P 500 was introduced in 1957, and in 1966 the company was sold to the McGraw-Hill Companies and became part of the group’s Financial Services division. Today, S&P is numbered among the Big Three ratings agencies, alongside Moody’s Investor Services and Fitch Ratings.
Despite what anyone thinks of ratings agencies, the US government is faced with this budget deficit that needs to be dealt with at some point (and which S&P thinks it can’t do – at least not very quickly).
Republican congressman Paul Ryan of Wisconsin, the new chairman of the appropriations committee of the House of Representatives went to great lengths earlier in April to roll out a deficit plan that promised to cut the deficit by cutting spending on virtually everything. It is the antithesis to the Democrat (and Fed) plan to increase spending and the amount of liquidity in the market in the hopes of triggering greater spending and more tax revenues which would reduce the deficit. The two plans are about as far apart in ideology as they could possibly be, and neither side seems eager to take the necessary steps to form a long-term plan on which all can agree.
With the second phase of Bernanke’s quantitative easing plan ending in June, nobody seems to have a long-term plan that will please both the Democrats and the GOP (and the Tea Party fundamentalists). S&P has said America’s ratings may suffer a downgrade within two years if nothing is done.
Despite all the bluster about ratings not being the real deciders of the value of sovereign bonds or markets, Wall Street very clearly thinks a downgrade of the US’s rating would be a very big deal and wants something to be done about the budget deficit. The White House clearly acknowledges Wall Street’s position – if not for the same reasons – that something needs to be done.
S&P’s negative outlook on the US’s bonds will help hurry along the process that will see Democrats and Republicans (one hopes that the Tea Party would have been rightly shown the door by this point) sitting down to hammer out a budget deficit reduction plan that isn’t just a 50-50 compromise, but a genuine long-term strategy to bring America’s economy back on the rails. S&P just wants everyone to get along. For a good business, you know. DM
- S&P lowers its outlook on US decline; stocks sink in The Washington Post;
- Stocks sink after S&P issue warning on US debt in Bloomberg Businessweek;
- Ratings downgrades do not equal higher interest rates in Business Insider;
- Zyblock Says S&P `Negative' Outlook a Warning for U.S. at Bloomberg (video);
- Jon Stewart: Ryan's Private Savings - Republican Deficit Plan on The Daily Show (video).
Photo: A trader looks at his screen on the floor of the New York Stock Exchange June 29, 2010. REUTERS/Brendan McDermid
- Sipho Hlongwane