American Credit for Dummies

Posted by David Smerdon on Aug 21, 2011 in Economics, Non-chess, Politics |

It’s been a wild and woolly couple of weeks for international markets and economies ever since the surprise downgrade by S&P of the US credit rating to AA+ on August 5.

Whoa.  Does anything in that sentence make sense to you?

If not, read on.  There’s been a lot of economic-jargon thrown around since then, a lot of it unintelligible to most of us despite its importance.  A lot of my friends have asked me to explain what’s going on in simple terms, assuming, somewhat naively, that working at Treasury means I have a clue what’s going on in the global economy.  That said, I am quite good at dumbing things down (insert punny anti-intellect jibe here), so here we go.

What’s that?  Oh, you want puns, do you?

The US economy: Putting downward pressure on Peruvian yoga classes since 2009.

 

 

What is a credit rating?

If you lend me $100, you’d want to first know what the chances are of me paying you back.  If you think I’m trustworthy and not at all dodgy, you might ask me to buy you a coffee when I pay you back, as a little token of thanks.  The dodgier you think I am, the more ‘interest’ you might want to charge me – maybe you’ll ask me to pay you back $110.  If you think there’s a very high chance I’ll blow the cash on tequila shots or novelty chess pieces, you might even ask for $150, to compensate you for the risk.

Instead of ‘trustworthy’, ‘dodgy’ and ‘scum’ as measures of my ability to repay, though, it’s more useful to have some sort of general rating that everybody can understand, and use to compare to other people.  That’s basically what a credit rating is – it’s a measure of how likely it is I’ll be able to pay you back, or worded another way, it’s the chance that I go bankrupt and default on the loan.  The worse my credit rating, the higher the interest, or risk premium, that you’ll charge me – and so it becomes more expensive for me to borrow money.  If I’m in a bit of a financial pickle, this is very bad news indeed.

But instead of rating people like me, a credit rating agency usually rates companies and large borrowers – including countries.

The US credit rating: a dangerous see-saw

 

 

What is a credit rating agency?

A credit rating agency (or CRA) is a company that assigns credit ratings.  There are lots of them around the world, but you really only need to know about the big three:  Standard and Poor’s (or S&P, the biggest), Moody’s, and Fitch.  Unfortunately, and really annoyingly, these three don’t have the same ranking system for ratings (the Bank for International Settlements has a comparison table here, if you’re interested).  In general, though, S&P’s is the standard reported, but all you really need to know is:  A’s are better than B’s, more A’s are better than less A’s, and pluses are better than minuses.  So, for instance, AAA is the best; AA+ beats AA; and A- beats BBB+.  Each rating can also get a little qualifier after it, such as “with a negative outlook” or “with a positive outlook”, to give you an idea which way it’s leaning.

The ratings can be applied to products, such as a corporate bond offer (basically, when a company wants to borrow money from the market), a corporation itself, or a state or country.  And given that the rating measures a risk of default, or bankruptcy, you’d be safe in assuming that most large sovereign nations would have pretty good ratings – after all, what are the chances of a first-world COUNTRY going bankrupt?

CRAs copped a lot of criticism in the wake of the ’08/’09 financial crisis, largely due to their failure to properly rate securitised derivatives (the financial products, most based on the US sub-prime mortgage market, that caused all the drama).   A lot of these ‘junk bonds’ were given AAA ratings, despite being incredibly risky in the event of a housing collapse.

(Consequently, the international financial organisations and the G20, largely led by the big European powers, attacked the CRAs with all sorts of regulatory measures.  There was probably a bit of revenge underlying this, as the big three CRAs are American, and the US (particularly Wall Street) was generally considered to blame for the global turmoil that followed.  Australia mainly held off on flaying the CRAs alive, largely because we believed that (a) we all got caught out in the crisis, and none of us realised just how overblown the US housing market was, and (b) in general, we came out of the whole crash relatively unscathed.)

The US debt crisis - Up a certain creek without a certain paddle.

 

 

So what happened?

On August 5, S&P (an American company, remember) downgraded the US sovereign rating from the top rank of AAA to AA+, with a negative outlook.  Not a big jump, you might think – but, remember, this is a concrete fall that says the US Government is now more likely to go bankrupt.  And this is the first time the US hasn’t been rated AAA since it was first assigned a rating in 1917.

The rating wasn’t downgraded because of any one feature.  For instance, this was certainly not the first time in US history that Congress was forced to pass a deficit reduction plan due to worries over repaying its loans.  And it’s not the first time the US economy has looked a little shaky – unemployment and inflation fears may be high, but they’re certainly not unheard of.

But it was the combination of these fears, as well as grave concerns over the US policy process in general after the last-day deal was clinched, that really spooked S&P into dropping the rating.  The downgrade really signals a lack of faith in the whole congressional system, which is a far trickier political reality that will have to be fixed separately to economic concerns.

The US economy - hanging by a thread.

Now what?

I don’t pretend to know anything about politics (I barely pretend to know anything about economics), so I’ll steer clear of that debate.  But going back to our $100 example at the start, the US has now become ‘dodgier’ as a borrower, meaning lenders are going to demand more interest before they agree to lending the US money.  That means it’s going to be more expensive for the US to patch up its debts – a lot more expensive.  And because the US Government is going to have to pay more to borrow money, this makes borrowing money more expensive for other borrowers, such as US companies wanting to expand or innovate.  In effect, money just got a whole lot more expensive for everyone.  And while the US Government has no choice but to borrow, whatever the cost, private companies may just choose to put the brakes on operations for a while until things recover.  The Government may inadvertently start ‘crowding out’ its private borrowers, slowing down the whole economy.

And a slowing economy is a very, very bad thing right now.  That was the driving fear behind the controversial (but successful) Australian stimulus package, which basically saw the Government handing out ‘free’ money to try and keep the economy moving forwards.  A slowing economy puts upward pressure on unemployment, it makes it harder for a Government to build its revenue, and it sends investors looking overseas for places to put their money.  In short, it starts what you may have heard of a ‘downward spiral’, where every falling domino moves a country closer and closer to the brink.

Still, I don’t want to get you too excited by all this.  For one, the US is the biggest economy in the world, and they have a lot more wriggle room than smaller nations (say, Greece).  What’s more, Moody’s and Fitch both decided to hold off on downgrading the US sovereign rating, showing that there’s a little bit of debate even among the experts as to just how bad things are.

And besides, a lot of the impact of credit rating movements are relative.  If you have lots of investment options at AAA, then me having a AA+ rating is a real issue – but if all our friends are also at AA+, then I’m suddenly not so worried that I can’t find someone to give me a reasonable loan.  And right now, the economic turmoil and widespread panic at fears of a double-dip recession seem to be universal.

Ultimately, the US is not going to go bust.  But this latest incident could well accelerate the inevitable transition in the global order from the US to China as the world’s economic superpower.  It’ll still take a few decades, but perhaps we’re a little further along the path to the US dollar taking the silver medal in terms of world currencies.  (I took great pleasure in teasing my American housemates in Peru that my smoothies cost “less than one of MY dollars, but more than one of yours!”)

US Credit - a scary monster.

There, did any of that make any sense?  I should write some sort of disclaimer on all this, but surely you trust me, right?  Here, how about I show you:  Give me $100, and I’ll show you exactly how the US economy works…

4 Comments

Vlad
Aug 21, 2011 at 4:47 pm

Well, let me add my couple of cents. As you correctly saying – everything is relative. The fact that Australia still has AAA could be a good thing (for Australia) in a long run. Maybe some of these multibillion companies will find it beneficial to reallocate their head offices from a country with AA+ to somewhere with AAA.:)


 
...Bob...
Aug 30, 2011 at 5:24 am

Hey, I’m not sure if you may remember me, but I played you in the simul at the commonwealth, you started the first game with me… Needless to say I got thrashed but on the post, I was wandering I want to become an actuary. Would you suggest it even though the whole US could be hating you all the time?


 
David Smerdon
Aug 30, 2011 at 11:17 pm

Hey Bob! I would always suggest that anyone keen on actuarial studies, and with the capacity, give it a go. It’s challenging but incredibly rewarding, and my actuary friends have successfully debunked my preconception that actuaries are more boring than accountants…

The US hates on a lot of people; hardly a deterrent. Possibly, in fact, the opposite.


 
Kobus
Sep 1, 2011 at 5:54 am

Its actually Kobus, I had a lot of fun bragging in economy about credit ratings:)


 

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