Tuesday, March 30, 2010

Credit Rating Agencies Again Protecting Subprime Securities

So argues this article. Only this time it is not subprime mortgages, but subprime government debt from the U.K. and U.S, governments. Is it right? Both yes and no.

It would be irrational to expect any near term default from either the U.K. or U.S governments. In part this is because they receive good credit ratings.

Now many will say "wait a minute: are you in effect saying that they receive good credit ratings because they receive good credit ratings?". The answer to that question is "that's exactly what I am saying". Credit ratings are to some extent self-fullfilling prophecies. If they receive high credit rating then they will have no problem taking on new loans to cover deficits and maturing old debts, but if their ratings are lowered they will have much greater difficulty doing so, thus "confirming" the downgrade (This is just another reason why I don't think anyone should trust rating agencies). The fact that Greece's ability to refinance their debts at a reasonable cost declined dramatically after they were downgraded is just one example of this.

Another reason to believe their won't be any U.K. or U.S. default is that both governments have easy access to "printing presses", meaning that debt obligations in effect can be met by "printing money", as long as governments don't believe there will be any dangerous inflationary consequences from this. And neither the U.K. nor U.S. governments believe that this is a risk right now.

So, the risk of a U.K. or U.S. default is basically zero for the time being, and will remain so for several years. However, if several years from now the inflationary outlook changes in the U.K. and U.S., then this will limit the ability of them "printing their way out of trouble". And if rating agencies at that point turn against them, then the downgrades that would then follow would have a negative "self-fulfilling prophecy" effect on their ability to refinance their debts.

Moreover, to the extent that the U.K. and the U.S. "print their way" out of problems, this will reduce the real value of bonds, and thus in effect amount to a partial default.