Austerity Doesn’t Pay as Debt Markets Ignore Rating Cuts
Britain is forcing Stephen Jobling and his stroke patients to defend the nation’s AAA credit rating.
Staffing at the National Health Service hospital ward where Jobling works was reduced by about half in the U.K.’s deepest drive since World War II to shrink its deficit. The goal was to avoid losing the top credit score, which might risk higher interest expenses, according to the government of Conservative Prime Minister David Cameron.
“If they could see these people suffering while we have two members of nursing staff running round trying to wash, dress and feed 20 patients, they would think twice,” says Jobling, 27, a nurse at Lincoln County Hospital in eastern England. “You should be looking after your people. You shouldn’t be bothering about some credit agency from somewhere else.”
The bond market says he’s right. After Moody’s Investors Service issued a “negative” outlook for U.K. debt on Feb. 13, yields on government securities relative to benchmark U.S. Treasury debt fell over the next month, instead of rising.
“I don’t think we should be slaves to the ratings agencies,” Mervyn King, governor of the Bank of England, told lawmakers on Feb. 29. “What we’ve seen is, the action they took recently did actually have no impact on the yield that people in the market were willing to lend to the U.K. government at.”
It’s not just Britain. After Standard & Poor’s stripped France and the U.S. of AAA grades, interest rates paid by the countries to finance their deficits dropped rather than rose. For investors and policy makers, predicting the consequences of a rating change by S&P or Moody’s -- the dominant issuers of debt scores -- may be little different from flipping a coin.
(For an interactive graphic, click here.)
Almost half the time, government bond yields fall when a rating action suggests they should climb, or they increase even as a change signals a decline, according to data compiled by Bloomberg on 314 upgrades, downgrades and outlook changes going back as far as 38 years. The rates moved in the opposite direction 47 percent of the time for Moody’s and for S&P. The data measured yields after a month relative to U.S. Treasury debt, the global benchmark.
The rating companies are still warning of downgrades while defending their assessments against critics. Moody’s said June 8 that all sovereign ratings in Europe would be reviewed, including Germany’s Aaa, if Greece leaves the region’s monetary union. The credit standings of Cyprus, Portugal, Ireland, Italy and Spain are deteriorating, the company said. The U.S. may have another downgrade by 2014, S&P said June 8.
The ratings “have more potential to do harm than good,” said John Hund, a finance professor at Rice University in Houston, in an interview. Hund wrote his doctoral dissertation on sovereign debt-market volatility and measures of sovereign risk. “It’s hard for me to see their value.”
Credit grades on government bonds have influence far beyond their technical role of describing the likelihood a nation will fail to service its debts. S&P’s downgrade of the U.S. last year contributed to a global stock-market rout that erased $6.1 trillion in value between July 26 and Aug. 12. In response to the lowered rating, the market sent yields on Treasury bonds to record lows rather than driving up rates.
They’ve stayed there. The U.S. government sold $29 billion of seven-year notes at a record low yield of 1.203 percent on May 24. The Federal Reserve has helped drive down yields by selling short-term U.S. bonds while buying longer-term securities.
The austerity policies prized by the rating companies have the global economy on the brink of renewed recession, according to Paul Krugman, the Nobel laureate economics professor at Princeton University. As government funding shortfalls from the U.S. to France to Spain widened during the recession, S&P and Moody’s stepped up warnings and downgrades of sovereign debt.
“Their austerity is leading to depressed economies, which is worsening fiscal prospects,” Krugman said in an interview May 9. “You’re kind of in an endless downward loop here, where you cut and the fiscal prospect looks worse, so to keep the rating agencies happy, you cut more.”
As part of the deal that raised the U.S. debt limit three days before S&P’s downgrade, $1.2 trillion in automatic spending cuts over the next decade will begin to take effect at the end of this year unless Congress and President Barack Obama block them. The tax cuts enacted by George W. Bush in 2001 are set to expire Jan. 1. That fiscal cliff may send the U.S. into recession again, the Congressional Budget Office said in May.
The U.K. scaled back public spending over the next four years by 81 billion pounds ($127 billion) while raising taxes, including what critics called a “granny tax” on the elderly. The austerity moves eliminating thousands of government jobs helped push the British economy back into recession in the fourth quarter, according to David Blanchflower, a former Bank of England policy maker. France and Spain took similar steps to shrink deficits even as the global economy stagnated.
The U.K. economy may grow 0.8 percent this year, according to the International Monetary Fund, while euro-area output contracts 0.3 percent and the U.S. expands at a 2.1 percent rate. The IMF has lowered its forecast for every EU country since last year.
The U.S., even with little likelihood of a default, fought the prospect of a downgrade. Treasury officials exchanged at least 158 e-mails with S&P from April 2011 until the rating change last August, according to materials obtained by Bloomberg under the Freedom of Information Act.
John Chambers, managing director of sovereign ratings at S&P, sent a draft of the company’s first-ever downgrade of the U.S. to the Treasury at 1:42 p.m. on Aug. 5, according to documents obtained by Bloomberg. Chambers e-mailed Matthew Rutherford, then the Treasury’s deputy assistant secretary for federal finance, less than three hours later to say that the company was rechecking the fiscal scenario baseline and would call in a moment. S&P downgraded the U.S. at about 8:20 p.m.
S&P’s decision was flawed by a $2 trillion error, according to the Treasury Department. Moritz Kraemer, S&P’s head of sovereign ratings for Europe, the Middle East and Africa, said April 24 that “there was no mistake” and that the discussion hinged on which nonpartisan Congressional Budget Office fiscal scenario baseline to use in the rating company’s credit analysis. S&P said using the department’s preferred spending measures in its analysis didn’t affect its credit grade.
Moody’s and S&P were already controversial after they helped fuel a global housing bubble by awarding AAA scores to subprime mortgage investments, creating demand for the flawed issues, which led to more bad mortgages being made. The rating companies engaged in a “race to the bottom,” inflating credit grades to win business from Wall Street banks, a Senate panel reported last year.
Thousands of these bonds plunged in value in 2008, which led to worst financial crisis since the Great Depression. Those soured securities were part of the reason the U.S. set up a $700 billion program in 2008 to bolster the financial industry. The crisis also spurred $787 billion of tax cuts and spending to help the U.S. economy. The U.K. created a 500 billion pound package to rescue its banks, and the European Union started a 200 billion euro ($252 billion) stimulus program.
Now, after governments widened their deficits to stem the crisis, their credit grades are under pressure from the same rating companies whose actions helped cause the financial turmoil.
“How do you have any faith in them given they were part problem?” Blanchflower said.
S&P’s roots go back to 1860, when Henry Varnum Poor published a comprehensive report on the financials of U.S. railroads. Journalist John Moody published his first railroad ratings in 1909.
In 1936, the U.S. Comptroller of the Currency banned banks from holding bonds that were below investment grade. In 1975, the Securities and Exchange Commission began using credit ratings in its rules, specifying that the only companies whose grades qualified were S&P, Moody’s and Fitch Ratings. The SEC designated them as nationally recognized statistical rating organizations, or NRSROs. There are now nine of them.
“That increased the monopoly power of Moody’s and Standard & Poor’s and Fitch,” said Richard Sylla, a financial historian at New York University’s Stern School of Business, in an April 27 telephone interview. “It was a bad move on the part of the government. It was a big favor to the rating agencies.”
Now S&P provides 42 percent of all credit ratings, and Moody’s, 37 percent, according to the SEC. The firms are for- profit units of publicly traded companies. S&P is part of McGraw-Hill Cos. (MHP) and Moody’s is a unit of Moody’s Corp. (MCO) Fitch is half-owned by Hearst Corp., the publishing company.
S&P and Moody’s rate thousands of sovereign debt issues from the top score of AAA down, 21 steps lower to D for S&P and 20 levels to C for Moody’s. Germany, with a top ranking, can borrow for 10 years at 1.4 percent. Greece, with an S&P rating 17 steps lower and a bottom-rung Moody’s grade of C, has to pay 18 times as much.
Investors also sometimes disregard ratings on corporate debt. For example, after Moody’s lowered its assessments last month on DNB Bank ASA of Norway and Nordea Bank AB and Svenska Handelsbanken of Sweden, yields on their bonds fell rather than rose. Investors said they were relying more on their own analysis than the credit scores.
Deficit-cutting policies have fueled Occupy protest movements, contributed to the election defeats of governments in Greece and France and eroded support for German Chancellor Angela Merkel. Newly elected French President Francois Hollande in May pressed European Union leaders to abandon austerity and fuel growth.
Regulators and politicians in the U.S. and Europe are considering proposals to replace ratings by S&P and Moody’s on sovereign debt. In April, Bertelsmann Foundation, a private organization founded by the former head of Europe’s largest media company, proposed a “blueprint” for creating a nonprofit sovereign credit-rating entity.
U.S. regulators, required by Congress to remove credit ratings from banking rules, devised a plan in December that would base bank capitalization requirements on classifications by the Organization for Economic Cooperation and Development. That intergovernmental group, two-thirds of whose members are European Union countries, considers most EU sovereign bonds risk-free.
The European Parliament’s economic and monetary affairs committee voted today in Brussels to scrap most of a proposal to force businesses to rotate the credit-ratings company they hire to assess their debt, while backing tighter restrictions on sovereign-debt ratings.
France has led calls to create a European alternative to S&P and Moody’s. Hollande advocated a government-funded agency as he campaigned against Nicolas Sarkozy, who watched as France lost its AAA rating even after his push for austerity. Denmark, which holds the rotating European Union presidency, said May 21 that it won backing in the 27-nation bloc to curtail the influence of rating companies and pledged to push for more competition in the industry.
“It’s almost as if they’re trying to admonish the countries to get their financial books in order,” said Chris Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi UFJ Ltd. “They’re really doing the world a huge disservice by frightening financial markets.”
The rating companies say they aren’t prescribing policy. S&P says its sovereign ratings have a “robust long-term track record.” Moody’s bills its grades as a “credit passport” for capital.
“The rating agency is not trying to predict the direction that credit spreads will move over the next few months,” said Richard Cantor, chief credit officer at Moody’s, in an e-mail. “We have only one objective, which is to assign ratings that are indicative of the relative risk of default and losses.”
Market reactions to rating moves can involve “non-rational behavior,” said Peter Rigby, director of rating services at S&P. For example, if S&P issues a “negative” outlook, investors may drive the yield up too far because they don’t know how many steps a country’s debt may be downgraded, he said. Rates may then ease after the company issues its new credit assessment.
“If we do change a rating -- lower a rating -- that in essence maybe sets a floor,” Rigby said. “So actually prices would tighten up to the new level.” Comparing market reactions with outlook and rating changes “would completely miss that phenomena,” he said.
S&P’s credit downgrades in Europe reflected threats to economic growth as well as risks including “tightening credit conditions,” the company said in January. It warned that “a reform process based on a pillar of fiscal austerity alone risks becoming self-defeating, as domestic demand falls.”
Bloomberg compiled data on changes in credit outlook and ratings along with bond yields for 30 countries as far back as 1974. They are Argentina, Australia, Austria, Belgium, Brazil, Canada, Chile, China, Columbia, Denmark, Finland, France, Germany, Greece, Indonesia, Ireland, Italy, Japan, Mexico, The Netherlands, New Zealand, Norway, Portugal, Russia, South Korea, Spain, Sweden, Turkey, the U.K. and the U.S.
To adjust for variations in market sentiment, the data compared yields with U.S. Treasuries. American debt serves as a benchmark because it is issued in the global reserve currency. In the case of the U.S., absolute yields fell. Measuring variations after 30 days allowed time for markets to adjust to assessment changes while minimizing the effects of subsequent unrelated events.
Other organizations have also used market prices to study the effectiveness of credit grades, including the International Monetary Fund, the European Central Bank and academics at Rice University, Indiana University and American University. In a January analysis of Moody’s rating changes, researchers at the IMF used credit derivatives to show that prices moved in the expected direction 45 percent of the time for developed countries and 51 percent for emerging economies. For outlook changes, the ratios were 67 percent and 63 percent.
Like Cameron, France’s Sarkozy in June 2010 made protecting the country’s top credit rating a priority. His government raised the national retirement age to 62 from 60. That September, he announced the deepest budget cuts in two decades, citing the need to defend the credit ranking.
S&P rewarded those moves on Dec. 23, 2010, affirming France’s AAA rating because of the “wealth and depth” of the economy and the view that Sarkozy’s government would narrow its budget gap. Within the next year, the credit rating became a sideshow as the Greek credit crisis put the stability of the euro and the country’s banks in play.
By last December, Sarkozy was saying a downgrade “would be an additional difficulty, but it’s not insurmountable,” in an interview with Le Monde. S&P cut its rating to AA+ from AAA on Jan. 13, saying policy initiatives “may be insufficient” to address “systemic stresses in the euro zone.”
The bond market balked at the ruling, making it cheaper for France to borrow after the downgrade. Sarkozy’s budget cuts contributed to his defeat last month as French voters elected Hollande, an advocate of growth rather than austerity. The new president is moving to reinstate retirement at age 60 for some workers.
Spanish Prime Minster Mariano Rajoy on June 9 accepted a 100 billion euro bailout from the European Union to defend the country’s banks and the government’s ability to finance its deficit. Since his election last November after promising not to raise taxes, not to make firing workers cheaper and not to cut spending on education and health, he did all of those things in Spain’s deepest austerity drive in more than three decades. The economy is heading for a decline of 1.7 percent this year.
The goal is to convince investors the country won’t default as borrowing costs exceed 7 percent, Rajoy said. The yield on 10-year Spanish bonds jumped to 7.29 percent yesterday after declining to 6.1 percent on June 7.
Spain paid 0.18 percentage point less to borrow than the U.S. as recently as April 2010, even after S&P cut the country’s top grade in January 2009. Moody’s stripped Spain of its Aaa rating in September 2010.
Moody’s has downgraded Spain four times since then, most recently by three steps to Baa3 from A3 last week, and S&P cut its rating to BBB+ in April, citing the risk that the government might not meet its deficit-cutting targets.
Spaniards are paying higher taxes and losing government services. In Valencia, 50-year-old Palmira Castellano says she can’t get out of the house since the end of a benefit that enabled her to hire someone to care for her disabled daughter Sara a few hours at a time.
“Everything is falling apart -- look at the health system, education,” Castellano says. “All the rights that were acquired over so many years are put into question.”
Austerity came to Britain after elections in May 2010 brought a coalition led by Cameron to power. Chancellor of the Exchequer George Osborne set out to reduce the national deficit to 1.1 percent of economic output by 2015-16 from more than 10 percent in 2010. The government delayed and reduced future pensions for workers like Jobling and tripled university fees.
Revenue increases include freezing a tax allowance for people over 65 which was introduced in the 1920s by Winston Churchill, according to Osborne’s most recent budget in March. The Office for Budget Responsibility says the government’s plan will cut more than 700,000 public jobs --including teachers, nurses, prison officers and police.
Protecting Britain’s credit rating “was the be-all and end-all” for Osborne, said Blanchflower, who is now an economics professor at Dartmouth College in Hanover, New Hampshire, and a contributing editor for Bloomberg Television. Credit ratings are “making everything more difficult than it could be without them.”
Osborne said April 13 that S&P’s AAA rating on British gilts “is a reminder that Britain is weathering the international debt storms because of the policies we have adopted and stuck to in tough times.”
Britain’s austerity drive has made the stroke ward at Lincoln County Hospital seem “like a battlefield” at times, says nurse Jobling. During some shifts, staff reductions have left 20 patients in the care of himself and two assistants, down from seven or eight workers, he said.
One night last winter, one of the wards ran out of space for patients, and two octogenarian women were left unattended at 2 a.m. in a waiting area pending their discharge the next day, Jobling says. In another case, he and two assistants struggled to care for a patient who had stopped breathing while another one was choking on dinner, he says.
“It’s just crazy,” Jobling says. “We had to choose which patients to save.”
Under the Cameron-Osborne austerity program, he says, his pay probably won’t rise from 21,000 pounds annually, after a 250 pound raise in April, and he fears losing his job. According to the Royal College of Nursing, as many as 61,000 National Health Service positions may be eliminated. The Department of Health disputes that estimate.
“The U.K. shouldn’t care at all what its rating is,” says Vincent Truglia, managing director of New York-based Granite Springs Asset Management LLP and a former head of the sovereign risk unit at Moody’s. “A rating is not what you’re supposed to be interested in. You’re supposed to be interested in the right public policy.”