Monday, August 08, 2011

It's the Economy Stupid; About That S&P Downgrade, Ratings, and Fundamentals

The DJIA is down over 200 points this morning, but Treasuries are actually showing serious strength. It's gotten to the point where even Warren Buffet has said that the S&P downgrade was wrong. S&P's spoke loudly and clearly when it downgraded US debt, but the Treasury market on Monday didn't appear to be listening; it was rallying. Buffet says the US Rating Still AAA, No Matter What S&P Says
"If anything, it may change my opinion on S&P," the legendary investor said.

Buffett is a big shareholder in Moody's [MCO Loading... () ], rival to S&P.

And Buffett is putting his money where his mouth is. As of June 30, Buffett's Berkshire Hathaway [BRKA 106450.00 -850.00 (-0.79%) ] had $47 billion in cash and equivalents. Buffett tells me that at least $40 billion of that is in U.S. Treasury bills. Not only that, Buffett says almost all of his own personal holdings in cash and equivalents are in T-bills as well.

"I wouldn't dream of putting it anywhere else," says Buffett, adding that at Berkshire, the only reason he's sold U.S. Treasurys in the past is to buy stocks or make acquisitions. And Buffett says Berkshire is still buying T-bills, even though yields have fallen so low. "If I have to buy (Treasurys) at a zero percent yield [cnbc explains] , I will," he says. "I don't like it, but we'll do it."
Well, considering that he's a major investor in S&P's competitor Moody's, you have to take some of this with a grain of salt.

Frankly, I find the focus on the downgrade to be misleading. After all, the same credit watchers completely botched the CRA and real estate meltdown - claiming that all kinds of investments were safe when they were anything but. It's quite possible that they've been overstating the strength of the various paper across sectors for years - and that they could have downgraded the US at any number of points in the past couple of years. That Moodys hasn't has as much to do with politics as the S&P decision to downgrade.

Still, it's all relative as far as risk is concerned. If you're an institutional investor, where are you going to put your money in a safe haven? The US is still a better risk that pretty much everyone else. China may be squawking loudly about things, but they've got their own mess and aren't nearly as transparent on their financial situation as the US. That's the position that Buffet is really iterating - that with all the problems with the US market and financial situation, it's still a better risk than everyone else. Despite the brinksmanship over the debt ceiling, it got done and the US still paid its bills. It was an ugly mess, but the ceiling was advanced. It will continue to be advanced despite the know-nothings in the Tea Party who are trying to disrupt all manner of governance simply by saying no to anything and everything.

It's the underlying economy that continues to be the drag on the markets. Real estate is dragging down manufacturing, fewer jobs and unemployment are all factors, and there's little that the federal government can do at this point despite all the talk of stimulating jobs growth. A new stimulus package wont get off the ground with the Tea Party firmly in control in the House, and taxes can't be cut further in many instances because the Senate is controlled by the Democrats. Neither side is going to compromise and this will again be the central issue in the 2012 elections.

Nate Silver at the NYT takes S&P to task for all manner of problems with how it issues its ratings on countries. Perhaps the most serious problem deals with how the S&P issues only step warnings. It wont issue a major downgrade, but rather issues a downgrade and warns of further downgrades (that come in short order):
But this is essentially what S.&P. does. Rather than downgrade (or upgrade) a country by several notches, even when there is abundant to support it, they instead do so in stages. Greek debt, for instance, has been downgraded seven times since January 2009, as S.&P. has slowly caught up with the grim realities that investors had long ago perceived.

I suspect the reason that S.&P. behaves this way is because they know that their ratings can have reverberations on the market and are trying to avoid a sudden downgrade that might induce panic.

But in so doing, they are violating their mission of providing the most earnest and accurate assessment of a country’s default risk at any given time. A country that is downgraded from AAA to AA is riskier, in S.&P.’s view, than one that was just upgraded from A to AA — even though they now have the same rating — since the former country is likely to be downgraded again and the latter is likely to be upgraded again. S.&P. knows this, and smart investors know this. But they won’t tell you this because dumb investors might get spooked, which could rattle the markets.

A more cynical view is that S.&P. is playing the role of the schoolmarm, looking for excuses to reward or punish countries based on good behavior — and that this is getting in the way of their objectivity. Investors think, for instance, that France is 2 or 3 times more likely to default in the next five years than the United States based on France’s exposure to Greek debt. However, France maintains its AAA rating whereas the U.S. was just downgraded to AA+. Arguably, it is not France’s “fault” for being exposed to Greek debt — whereas the United States’ fiscal problems are largely of its own making. But France is probably the riskier bet all the same.

None of this is necessarily to disagree with the downgrade in the United States’ rating. A rating system based on objective factors, like debt-to-G.D.P. ratios, might plausibly have the U.S. rated even lower than AA+.

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