Opalesque Industry Update – Legg Mason Capital Management’s CIO Bill Miller lent his voice to those sharply criticizing Standard & Poor’s downgrade of US credit at the end of last week. In a statement released by the firm early on Monday, Miller says: |
“At best, S&P showed a stunning ignorance and complete disregard for the potential consequences of its actions on a fragile global financial system. S&P chose to take this action after the worst week in US equity markets since 2008, a week which not only saw stocks fall sharply, but which also witnessed a dangerous escalation in the ongoing European debt crisis with spreads widening to post-Euro records in systemically-important countries such as Italy and Spain amid general political paralysis. The action was wholly unnecessary and the timing could not have been worse. Compounding this, the reasoning was poor, and consequences both short and long term for the global financial system are completely unpredictable.
“It is totally unacceptable that privately-owned, for-profit companies should have special, legally sanctioned status at the heart of financial system to function as quasi-regulatory authorities whose opinions can determine what securities financial institutions can hold, how much capital they need, what the borrowing costs of every member of the system will be, all based on secret deliberations without any accountability. The disastrously flawed ratings of these agencies were at the heart of the financial crisis of 2008, and this unilateral action by S&P threatens to create mayhem yet again in the system by creating uncertainty about the ability of the United States to function in its unique and critical role in the global financial system.
“In any event, an agreement was reached, passed by comfortable majorities in both Houses, and it completely assures our ability to fund the country’s operations through the next election. It also initiated a process whose objective is to tackle the nation’s long standing fiscal imbalances, something that did not exist prior to this agreement.
“The contentious debate surrounding the debt ceiling succeeded in doing something important that had not been done before. It concentrated the public’s attention on our deep fiscal imbalances, and changed the governing priorities to include measures to address the unsustainable trajectory of government spending. There is now no serious debate about needing to reform and curb entitlement spending. Both parties agree on this. The debate is now centered on if any, or how much, revenue enhancement is needed. This is progress and should have counted for, not against, the US’s AAA rating, as Moody’s correctly opined.
“Second, S&P apparently gave little or no weight, or certainly insufficient weight, to the unique role the United States plays in the global economy. The United States is the largest, most productive economy in the world and the dollar remains the global reserve currency. There simply is no alternative to the dollar as the global reserve currency and as the instrument of global trade. The only other possible alternative, the Euro, is structurally flawed and is in what may turn out to be an existential crisis. Issuing our own currency means we can always settle our debts by printing more money if need be, so there is absolutely no question of our ability to pay.
“Our military spending exceeds 40% of the global total and is more than six times larger than China, the second largest spender. This spending provides a global security blanket for other countries such as Canada and Australia, both rated AAA, and as such represents a subsidy to other developed world economies.
“Our status as the dominant global economy, sponsor of the world’s reserve currency and as the only military superpower in the world makes us sui generis economically. That alone should be worth a rating at least one notch higher than anyone else, and probably accounts for Mr. Buffett’s comment about the US being “quadruple A.”
“Third, the market says S&P is wrong. The US enjoys among the lowest interest rates in its history coincident with the highest deficits and a daunting long term fiscal outlook. Yet when investors in a highly uncertain world are looking for safe assets, they invest in US Treasuries. We are borrowing at lower long term rates than we did when we were running a budget surplus and public officials began to wonder if we were headed for a shortage of US Treasury securities to buy. During the financial crisis in 2008, the worst financial crisis in history, investors flocked to Treasuries and the US dollar because they sought the safest, most creditworthy assets in the world. S&P seems not to have noticed this.
“As Warren Buffett has noted, fear is contagious and spreads quickly; confidence is fragile and only returns gradually and over time. S&P’s actions can only undermine an already weak level of confidence and raise uncertainty. At this point S&P has managed to create what Keynes called irreducible uncertainty: we just have no idea what the consequences may be of S&P deciding that the risk-free assets issued by the country that occupies a unique place in the global economy may not be risk free after all.
“S&P said they believed their downgrade was already in the markets as they had first flagged the potential for it to happen months ago, and again in July raised the prospect of a downgrade. Former Treasury Secretary Paulson said the same thing about Lehman brothers, pointing out he repeatedly said taxpayer money would not be used to rescue Lehman’s creditors. He believed that was in the market as well. He was wrong. Last week the Treasury’s Borrowing Advisory Council, which consists of senior people at the largest bond shops in the country, met and the minutes of the meeting indicated none of them thought a downgrade was imminent. Late last week, online prediction market Intrade listed the odds of and S&P downgrade by 2013 at 50%. So much for being in the market.
“One can only hope the market sees S&P’s precipitous and wrong downgrade as idiosyncratic, absorbs it without too much turmoil, and moves on, realizing the US at long last is about to tackle its fiscal imbalances while remaining the best credit in the world.
“The future, though, is obscured by clouds of uncertainty. No one can predict the consequences of S&P’s action. Perhaps there will be none. But complex systems can exhibit non-linear behaviors dramatically different from what the change in circumstance might seem to warrant. No one could have foreseen that a single Tunisian street vendor’s suicide would topple that government, the government of Egypt, dramatically raise oil prices, ignite civil war in Libya and unleash massive unrest in Syria.
“The consequences, if any, of S&P’s precipitous, wrong, and potentially dangerous decision will unfold in the next days and weeks. One consequence we can all hope for is that Congress ends the oligopoly of Nationally Recognized Statistical Ratings Agencies (NRSRO) before they contribute to or ignite another financial crisis. Even S&P agrees, stating to its credit that that regulatory reliance on ratings by NRSROs should end. By all means let’s have S&P and Moody’s and Fitch opine all they want about creditworthiness, but let’s have them do it in a free competitive market and not via a legally-sanctioned oligopoly who effectively regulate without oversight or consequence.