Debt limit, ratings and rating agencies

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With a government shutdown in the rearview mirror, the main political issue shifts to the debt limit. Recall that Congress provided the Treasury with a short-lived cash injection that kicked off the date when the debt limit will have to be raised (or suspended) until around December 15. That date is fast approaching, but so far there is no plan made public. to meet the limit.

This is a concern, at least for me, because even if the limit is eventually reached, a very complicated process that threatens default could lead to rating agencies downgrading the United States – which happened a few years ago. ten years. This possibility raises the question: should we care what the rating agencies think?

This is not a rhetorical question. In the aftermath of the financial crisis, rating agencies received a lot of criticism regarding their ratings of exotic securities structured around mortgages. The Financial Crisis Inquiry Commission (FCIC) said: “Financial institutions and credit rating agencies have embraced mathematical models as reliable predictors of risk, replacing judgment in too many cases. Too often, risk management has become a justification for risk. Even dissent by myself, Bill Thomas, and Keith Hennessey frowned: “Credit rating and securitization failures have turned bad mortgages into toxic financial assets. Securitizers downgraded the credit quality of the mortgages they securitized. Rating agencies have wrongly rated mortgage-backed securities and their derivatives as safe investments.

Yet that was ten years ago, and rating agencies had undergone huge management changes and investments in their approach to rating securities. Did it work?

Turns out there’s a great opportunity to review this. No one saw the COVID-19 pandemic coming, so this is a real independent shock to the financial system. This has caused many financial difficulties, including a sharp increase in corporate payment defaults worldwide. The chart (below) documents this fact for securities of companies rated by S&P Global; it is reproduced from its rating performance review in 2020.

Clearly, the corporate default rate has jumped north in 2020, although it remains below the obvious peak of the financial crisis. And, crucially, this is a global phenomenon (as the pandemic was), so it is not the artifact of any single country’s specific policy responses.

If the rating agencies have done their job well, these defaults should be concentrated on the lowest-rated bonds. As shown in the following chart (also reproduced from this report), default rates for bonds rated B- or higher have approached their historical average in 2020. But poor quality bonds have defaulted at a much higher rate. greater than history would have predicted.

In short, the rating agencies (S&P in this case) have done their job. Ratings provided information about credit risk, and when the environment became stressed, this information predicted defaults.

This is a far cry from the perception of 10 years ago. This suggests that the due diligence in the meantime has proven fruitful. It also suggests that Congress and the administration should not play with the debt ceiling to the point that the United States risks a downgrade.

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