Submitted by Peter Tchir of TF Markets
Equities in Dallas and Sovereign Debt Ratings
Sovereign Debt Rating Actions are Decided at the Highest Level within the Rating Agencies
“Equities in Dallas” was the worst job a trainee at Salomon brothers could get. I have to believe that the G-20 sovereign debt rating group was the equivalent at the rating agencies. It wasn’t volatile and sexy like Emerging Markets. It had nothing to do with the core business of rating corporate debt. It had even less to do with the fast growing structured product business. It must have been a pretty dull place to work. I think that is important because it means, certainly at this stage that all the decisions on sovereign debt are being made at a very high level within the rating agencies. Someone isn’t running some numbers and coming up with a rating proposal. Some people are sitting around in a room, trying to figure out what rating they want to give, or need to give, or can get away with giving. Knowing that these decisions are being made at the highest levels of the firm and have nothing to do with what any analyst in the area says or does is important in trying to figure out where the ratings go next.
Europe and EFSF will drive the next big move in the markets
Before going any further, I just want to re-iterate that the events playing out in Europe right now are likely to have far bigger influence on Monday’s trading than the S&P downgrade of U.S. debt. I have questioned whether EFSF could be implemented, and that even if it could be implemented, whether it would provide enough benefit to make a difference. It also seemed clear to me, that with each new version, more of the risk was being dumped into Germany’s lap, and that at some point Germany would get scared that all these bailouts would eventually drag them down too. That realization may be happening. If so, I expect that will drive the market and be responsible for the next 10% down move. I am still suspicious that they will launch some new and improved supersized program by Monday, once again with no details, and the market can rally and make the problem larger and even more intractable. Ultimately, printing money seems to be the only way out. We are also only 2 weeks away from what I view as a reasonable deadline for can kicking. August 20th is a big day for Greece with a bond maturing and several large interest payments due. If Germany or anyone else is getting cold feet , they might as well end it before they give away that much more money to Greece.
What can we learn about future rating actions from Friday’s downgrade?
One reasonable question that keeps coming up, is whether Friday was a signal of the beginning of another round of sovereign debt downgrades. Will the other rating agencies follow the lead and knock the U.S. down? Will S&P or the others take this as an opportunity to notch down some other sovereign ratings? France would be the key. If France loses its AAA rating, the EFSF doesn’t work as structured. Any charade that the EFSF isn’t Germany in drag (not a pretty image) would be shattered. The German people would realize that no matter what their politicians are saying, they would be taking on the debt of the PIIGS and be solely responsible for supporting the Euro. I think that will be too much, and the can will not be kicked.
Moody’s and Fitch and S&P Will Leave U.S. ratings where they are for awhile.
S&P took the U.S. off “negative watch” and moved it to the less imminent “outlook negative”. They don’t have to be in a rush to do anything else. I think they will see how this storm plays out. They made their statement and will be content to fade to the background for a little while if possible. In the end, had the elected officials not spent so much time saying that we could default, I don’t think they would have been in such a rush to downgrade. All else aside, when the President of a country states repeatedly that we could default, someone at the rating agency is bound to notice. Even the Italian politicians take time away from their various antics to mention that Italy is in great shape and will always pay her debts. I just don’t see S&P doing anything else in the U.S. for awhile.
Moody’s has the U.S. on outlook negative. They could downgrade the U.S., but this is where it is important to remember who is making the decisions. It is the most senior level of management at the agency. Do you really think they want to get hauled down to Omaha to explain to the Oracle how they downgraded his beloved AAAA country? I am sure that Mr. Buffett has almost nothing to do with the day to day operations at Moody’s, but he might make an exception in this case. For better or worse, you don’t make it to the top of Moody’s without having some political savvy, and you would have to think long and hard about knocking the U.S. down a notch, which is against everything your owner says. If it was any other country, my guess is that Moody’s would take the time to notch the U.S. so they could say they were prudent. But with a boss as famous and as pro-USA as Mr. Buffett I think they will keep the AAA for longer than they otherwise would.
Fitch has always been a distant third. They don’t have the U.S. on outlook negative right now, so they seem already set to be the least likely agency to downgrade the U.S. They received a lot of government/regulatory support in the 2000’s. The regulators pushed Wall Street to include a 3rd rating agency whenever possible. It was a big deal when Lehman (now Barclay’s) chose to use Fitch ratings when creating their benchmark indices. As the weakest, who has relied on government support to grow their business, their leaders also seem unlikely to want to downgrade the debt and deal with a loss of support. Egan Jones already downgraded and no one cares because they aren’t one of the big 3. The people in charge at Fitch know they got government support to get to the top, and are going to think long and hard before they do anything to lose that support.
This is NOT the start of a NEW program of downgrading sovereigns globally.
There is some concern this could be the first shot in a new wave of sovereign downgrades. If that is correct, then we are in some trouble, but I think S&P went out of their way to avoid having to downgrade other sovereigns. S&P spent so much time focusing on the politics in the U.S. as one of the key drivers of the downgrade that it gives them a lot of wiggle room. If they are asked about Japan’s rating compared to the U.S., no matter how much data people have showing Japan should be much worse, S&P can just play the partisan politics card. I think there downgrade language was carefully constructed to isolate the U.S. and the political environment. If it was on data only, there probably should be a lot of reshuffling of ratings. That is why they kept the reasons so much to the political side. That is why in the end no one cared about who was right or wrong about $2 trillion (a scary concept in its own right).
This came down to S&P taking the opportunity to downgrade the U.S., and blame it on the politicians. Had the S&P waited another couple of months, they might have had a more difficult time pinning the blame on the political process here. People would have asked why they waited so long, and they would have opened up a can of worms by having to discuss GDP, tax collection, spending, etc. In the end, they chose to act while the debt ceiling debacle was fresh on everyone’s mind and will use that reason to defend why they don’t downgrade other countries.
I think this is merely part of the general trend of sovereign downgrades, but reading too much into this, and saying it is the start of a more rapid downgrade process for sovereigns is likely incorrect.
France’s rating is the only one that matters anyways
If I’m wrong, and this is a trend to accelerated sovereign downgrades, there is really only one country that matters, and that is France. What are they going to do, change it from CC to CC-, or Ca to Cb? Greece is so far gone it doesn’t matter. No one believes they can tell the difference between A and BB, let alone CC and C. Italy and Spanish downgrades might move the market, but probably only briefly. A downgrade of Italy will send the market into a brief tailspin. Everyone will chatter about it, then realize, that it isn’t trading at yields anything close to its current ratings, the ECB will still let banks use it as collateral, and that no one other than some equity futures traders have been paying close attention to Italian or Spanish debt ratings anyways. A downgrade to China might move markets, but why they are only Aa3/AA- is a bit confusing to me to begin with given all the reserves they have. Either the rating agencies know something we don’t (ghost cities) or they have just been lazy and out of touch with reality.
France is the key, because right now, Europe needs to believe in EFSF to think it can escape the mess it has created. And EFSF needs the AAA countries to provide 100% of the issued debt. The AAA guarantors are Germany, France, the Netherlands, Austria, Finland, and Luxembourg. Finland and Luxembourg are small enough that they could be replaced if need be, but don’t seem at any risk of losing AAA even if the rating agencies are on a downgrade rampage. I have to admit, I am surprised at how big the GDP of Holland is, I really just underestimate it, but don’t see any reason they would have to worry about their rating. Austria strikes me as having some weak banks, but I don’t know enough about it, and it’s small enough, and there is no indication of any rating agency concerns, so I assume it will be left alone. Germany is so big and has shown itself to be such a strong economy, that there is zero chance the rating agencies would touch it.
France is another story. Their banks seem very exposed to the PIIGS. Their economy does not rival that of Germany. The agencies seem open to criticism of why they would leave France AAA and the U.S. as AA+. France is the second largest contributor to EFSF. If France loses its AAA, the EFSF concept is gone. I think Holland would decide that it was easier to take advantage of some of their special cigarettes and chill for a bit rather than up its commitment to the weak EU members. Without France, due to downgrade, and Holland due to deciding that it had all spiraled too far out of control, it would all fall on Germany. You have to assume, that on the back of a French downgrade, fear of being the sole supporter of a failing Europe would hit extremes, and the fear would be rational. If French loses its AAA rating, it’s likely Spain and Italy would have taken some multiple notch downgrades as well, making it impossible to restructure EFSF in a way that hides that it relies entirely on Germany.
If France goes, the EFSF goes, and we see real defaults in Europe. They might even trigger CDS Credit Events, but that won’t matter. Banks will be in big trouble, money markets will freeze and stocks will swoon. Over the longer term, I still think that would be the best, but none of the politicians in Europe think it’s a good idea to let defaults occur. They all like the idea of EFSF. And since it is clear that sovereign rating decisions are being made only at the highest levels within the agencies, they will be sensitive to this political pressure. They will likely try to negotiate commitments to keep ratings as part of the regulatory capital process if they play nice. It is the governments and regulators who give the agencies so much power by creating regulatory capital rules based on their ratings. I can easily see some trade-offs being negotiated. On an even simpler level, how much money will the rating agencies “earn” if the rate €1 trillion of EFSF bonds. The potential fee income might be enough to let the rating agencies justify keeping France as AAA. If not, look out below for stocks.