Standard and Poor’s Downgrade of the United States Long Term Sovereign Credit Rating from AAA to AA+

American Eagle on Perch, Skagit Valley, Washington (image on Photoshelter)

Rating agencies, including Standard and Poor’s, Moody’s and Fitch, use different, proprietary models to rate debt and financial strength. While there may be no such thing as a perfect model, each company promotes its own model and methodology. Rating agencies serve a purpose in providing the marketplace with information on the financial health of the companies, governments and financial instruments they rate.

Taking into account differences in models (and agency inclinations), it is not surprising that rating agencies should differ in their ratings from time to time. Thus, Standard and Poor’s downgraded the United States credit rating from AAA to AA+ while Moody’s and Fitch have maintained their ratings while warning that future downgrades were possible if the United States did not enact debt reduction measures and if the economy weakened.

A more definitive statement would have been made if all three major rating agencies had dropped the rating of United States debt.

Standard and Poor’s rating change reflects their perception of the political stasis leading up to the recent move to raise the debt limit.

The Standard and Poor’s downgrade remained in place after a $2 trillion dollar error in their calculations was discovered by the Treasury department. Standard and Poor’s defended their decision, reinforcing the perception that the downgrade reflected to a large degree the inability of our government to get the job done.

Standard and Poor’s is under attack for their rating of mortgage backed securities involved in the financial debacle of 2008. These securities were rated AAA just prior to their default. The U.S. Justice Department is investigating Standard and Poor’s for their ratings of these instruments.

The ratings process is complex. Complex models are involved. When the ratings model indicates problem areas indicating a potential downgrade a number of paths may be taken. A rating agency may work with the organization to solve its problems (or to assure the model is adequately capturing an organization’s weaknesses and strengths). Either way, the focus is to assure capital adequacy.

This may give the organization an opportunity to avoid a downgrade while fixing the problem and risk a potential disastrous cascade into insolvency. There is a balance of risks -- a cascading failure could be a far worse alternative both for the organization , related entities and the economy. However, measures taken to solve the underlying problems should be appropriate, rather than window dressing which overvalues assets or undervalues liabilities.

If the agency does not downgrade an organization (or financial instrument), they risk a potential hit to their reputation if the entity does tank while holding the original, pristine rating.

In many instances companies pay a significant fee to be rated. This raises the issue that the agencies are serving the companies they rate rather than the overall public (or potential investors). This issue is to some degree offset by the reputation issue that rating agencies face when they fail to downgrade a company (or financial instrument ) that fails. Their services are judged by their ability to accurately rate entities.

The actual downgrade aside, Standard and Poor’s was correct in its appraisal of the ineffectiveness of our government in addressing the national debt issues. Standard and Poor’s mentioned the political brinksmanship, differences between political parties, and the failure to consider tax increases among other issues.

The sad thing is that our elected representatives performed so horribly that it gave Standard and Poor’s an opportunity to downgrade government debt from AAA for the first time in the history of the United States. There are many that depend on the United States to provide a stable financial milieu; the threat of a default; the inability of some representatives to compromise was an arrogant abrogation of their electoral duty to act in the best interest of the United States.

It seem that the rating agencies are, in a way, a force unto themselves that rest above governments and pass judgement upon them. Do we really want the institution of money to rule us in this way?

Wikipedia article on 2011 downgrade.

Entitlements

Entitlements

Completing the George Washington Memorial Bridge (Aurora Bridge-SR99), Seattle, Washington, 1932 (B&W)

This photo of the George Washington Memorial Bridge (Aurora Bridge or SR 99) was taken by my father as it was being completed in 1932, during the period of the Great Depression. It was converted to black and white. Connecting Seattle’s Queen Anne Hill to Fremont, spanning over the Lake Washington Ship Canal, the Bridge’s construction was an engineering accomplishment in the midst of hard times.

A bridge spans an obstacle to bring two areas together, to allow passage. It may be used symbolically in others areas such as a music bridge, an interlude that connects two parts of a song, or a bridge loan (interim financing).

For me, it also symbolizes bridging the gap between work and retirement.

In these days before the August 2, 2011 deadline to raise the national debt limit, it also symbolizes the need to bridge the gap between parties, to compromise on a solution to our national debt problem. Should that attempt fail, it will symbolize solutions to solve the financial gap.

As we march towards a potential default of the national debt, a large part of the debate centers around the impact that entitlements have on our nation’s expenditures. Entitlements consist of Social Security, Medicare and Medicaid. Entitlements have grown to comprise a large portion of our nation’s expenditures and contributions to our nation’s burgeoning national debt.

Social Security comprised 20% of the nation’s 2010 fiscal year budget while Medicaid and Medicare together comprised 23% (Wikipedia). Together, the three programs comprised 43% of the nation’s 2010 fiscal budget. Moreover, the cost of these three programs are expected to grow over the coming years.

With such a considerable portion of our nation’s budget tied up in entitlement programs, it is difficult to find areas to cut. If you leave entitlements alone, you are left with 57% of the budget. If military expenses (20%) are left untouched, only 37% of the budget is left to work with.

Historically, the concept of cutting Social Security has been likened politically to touching the electrified “third rail”. Social Security, Medicare and Medicaid have a storied history and a large degree of public need and acceptance (and entitlement) that makes them difficult to reduce.

There has been a greater willingness to tackle the issue of entitlement programs in the recent national debt talks; however such endeavors may leave a sense of disconnect with the public who may be unaware of the cuts should they actually occur.

There are many factors reflected in the increases in entitlement costs (and their projected costs into future years). One common factor is demographics.

Demographics

Baby boomer demographics is a major reason for the increase in entitlement costs now and into the future. Baby boomers are considered to be those individuals born between 1946 and 1964, following World War II. There was a peak in births during that time period that has resulted in increased proportions of individuals for that cohort as the cohort has progressively moved down the arrow of time from birth to retirement.

Consider a snake that has swallowed a mouse for dinner; you can see the progress in the snake’s digestion of the mouse as the mouse’s shape progresses down the long sleek lines of the snake’s body. In a demographic diagram, the baby boomer population exhibits somewhat similar characteristics, impacting each age group disproportionately as it ages.

Thus, the increased birth rate during the baby boomer years results in increased expenses as baby boomers age. These increased older populations will stress entitlement programs, with fewer younger workers to provide the population base to pay for benefits for the older population.

The Challenge

The projected growth in entitlement spending represents a real challenge, and must be faced by creative solutions that address the problem for not just the immediate future, but for the long term. Such solutions must address needed social needs while at the same time managing costs.