To: Executives and Analysts of Standard & Poor’s, Moody’s, and Fitch
From: Martin D. Weiss President, Weiss Ratings
I challenge you again to promptly take the bold action that you have so far avoided — to downgrade the debt U.S. government in order to help protect investors and prod Washington to fix its finances.
I issue this challenge for three absolutely vital reasons:
Reason #1. Your current ratings of U.S. debt are fundamentally dishonest.
At the triple-A level — or just one notch below triple-A in the case of S&P — your ratings are greatly inflated and inconsistent with well-recognized realities …
• The sharp decline in the U.S. fiscal balance since 2008
• The U.S. government’s multiyear trillion-dollar deficits
• The massive buildup of debt, with larger increases expected in years to come
• The fact that, by nearly all measures, the U.S. government is now weaker financially than countries meriting your lower ratings, and
• The risk of uncontrollable consequences from the fiscal cliff.
Reason #2. Your ratings are unfair to investors.
By maintaining inflated ratings, you have helped elevate the price investors must pay for U.S. government securities.
You have also helped reduce the yield they can earn, compromising the livelihood of millions of American, especially retirees who depend on fixed-income investments.
And you have failed in your key role of warning the public about the true risks they are taking.
Reason #3. Worst of all, your ratings have supported the complacency in Washington that has lead us to this fiscal cliff!
By maintaining inflated ratings, you have helped enable our leaders to borrow and spend their way through the debt crisis.
You have made it easier for them to delay vital decisions to tackle America’s ballooning federal deficits.
And you have helped foster an environment of complacency that created many of the fiscal cliff disasters now upon us.
Why Have You Done This?
Do you believe — or are you afraid of those who believe — that it’s unpatriotic to downgrade the U.S.?
Certainly you know, from your decades of experience, that millions of investors — especially U.S. citizens — are damaged by the kind of complacency that your inflated ratings can create.
I’ll provide some specific examples in a moment. But for now, just look at it this way:
If the U.S. were under the threat of an imminent terrorist attack, our intelligence agencies would be criminally remiss if they deliberately failed to issue the appropriate threat-level downgrades.
And yet, here we are, facing the imminent threat of fiscal disaster, but you have done little more than hint at possible downgrades at some undetermined future date.
Are you afraid of condemnation by the U.S. government officials?
It is true that officials of the U.S. Treasury Department came down hard on Standard & Poor’s when it downgraded the U.S. last year.
But can’t you take the heat? Can’t you muster enough courage to simply declare that the emperor has no clothes?
Or are you just afraid of hurting your biggest paying clients?
I’m talking about the thousands of companies that are dependent on the U.S. government — banks that have received government bailouts, manufacturers that rely on government contracts, and any institution that holds large amounts of U.S. government securities.
Clearly, if you downgrade the U.S. government, you will be forced to seriously consider a chain reaction of downgrades for each of these companies — the same ones that pay you large sums each year for the ratings you give them.
This is an egregious — and extremely dangerous — conflict of interest. You must take concrete steps to overcome it.
More than ever before — especially in light of your ratings missteps of recent years — you now have one final opportunity to rise to the occasion and issue clear warnings!
Now — before the U.S. economy begins to feel the impact of the fiscal cliff, is your last chance to proactively downgrade Treasury notes and bonds, TIPS, Ginnie Maes, and all other long-term debts issued by government-run entities.
Needless to say, the downgrades would be historic, pressuring Treasury bond prices lower and adding upward pressure on long-term interest rates.
And undoubtedly, as we’ve seen before, backlash from government officials is to be expected.
But as history has proven repeatedly, the consequences of procrastination can be far more serious:
First, without the proper warnings, you help entice millions of hard-working citizens, retirees, and their intermediaries to pour even more money into a potential debt trap … or at best, to be severely underpaid for the actual risks they are taking.
Second, without the appropriate downgrade, you give policymakers a green light to make minimalist deals before the fiscal cliff yearend deadline and to perpetuate their fiscal follies after the deadline.
Worst of all, by continuing to reaffirm America’s inflated ratings, you help create a false sense of security overall — the recipe for a possible meltdown in financial markets when global investors finally do realize that the emperor has no clothes.
In the past, you have often hesitated to downgrade large institutions with deteriorating finances.
Please, do not repeat that error.
If you do, history shows that it can end in disaster, as illustrated by the following four case studies:
Case Study 1
Major Life and Health Insurance
Companies Failures of the Early 1990s
In a landmark 1994 study of rating agencies, the Government Accountability Office (GAO) concluded that you did not downgrade large insurance companies that subsequently failed — until it was too late for most policyholders.
The GAO defined “vulnerable” ratings as those that warned the public of future financial difficulties, finding that …
S&P did not issue a “vulnerable” rating for one of the biggest failed companies, Fidelity Banker’s Life, until six days before the failure; and it did not issue a vulnerable rating for another, Monarch Life, until 351 days after the failure.
Moody’s, to its credit, was the first to warn about the failure of Executive Life of California. However, it did not issue a “vulnerable” rating on Mutual Benefit Life, the largest insurance company failure, until two days after its demise.
In the same study, the GAO demonstrated that the nation’s leading insurance company rating agency, A.M. Best, also failed to protect the public.
Best did not issue a “vulnerable” rating on Executive Life of New York until the day after it failed … on Fidelity Bankers Life, until two days after it failed … on Mutual Benefit Life, until three days after it failed … and on First Capital Life, until five days after it failed.
Moreover, for Monarch Life, Best never issued a “vulnerable” rating, instead assigning a non-published rating four days after the company failed.
Result: In the final tally, over six million U.S. policyholders were caught in insurance company failures for which they received little or no warning from established rating agencies.
Moreover, two million of those policyholders had cash-value policies which were frozen and which were subject to serious losses due to the company failures.
Case Study 2
Enron Failure of 2001
The New York Times reported that you saw signs of Enron’s deteriorating finances in May 2001, but did little to warn investors until at least five months later.
Unfortunately, that was long after more problems had emerged and Enron’s slide into bankruptcy had accelerated. (See “Credit Agencies Waited Months To Voice Doubt About Enron.”)
At the time, you claimed you had no way of knowing about the company’s internal shenanigans.
But you also admitted that, well before the general public suspected wrongdoing at Enron, you were aware of at least one of the critical factors in the failure — that trusts related to Enron had made financial commitments which were tied to Enron’s own stock price.
How did you know? Because you rated the bonds and notes sold by those same trusts.
Nevertheless, it wasn’t until November 28, just days before Enron filed for Chapter 11, that you first lowered its debt ratings below investment grade.
Result: Thousands of investors and institutions suffered massive losses in Enron securities which they could have avoided with honest ratings.
Case Study 3
Mortgage Meltdown of 2007-2008
Congress, regulators, investors, and some of your former executives generally agree that:
• Your triple-A ratings on mortgage-backed securities grossly overestimated their credit quality;
• This played a pivotal role in the debt crisis; and
• The primary factor behind your inflated ratings were three conflicts of interest between you and the issuers, as follows …
Conflict #1. As with nearly all other ratings you issue, your mortgage security ratings were paid for by the issuers, empowering them to achieve undue influence over the ratings process.
Conflict #2. You earned substantial additional consulting fees to help structure the very securities you rated.
Conflict #3. You revealed your ratings formulas to issuers, helping them manipulate their data to game the system and more easily get high grades for their junk securities.
These conflicts help explain why …
Senator Al Franken sought to do away with your three-way oligopoly of the credit ratings industry. (See “U.S. amendment could curb rating agencies’ power.”)
A California court has decided that California’s main public pension system (CalPERS) can go forward with its lawsuit against Moody’s and Standard & Poor’s over investments that may have cost retirees $1 billion, claiming negligent misrepresentation. (“CalPERS suit against credit-rating firms advances.”)
And another 20 lawsuits are moving forward against you all over the world — specifically due to this egregious assault on investors. (“Copycat litigation threat for rating agencies.”)
Case Study 4
Major Investment Bank Failures
In The 2008-2009 Debt Crisis
When major Wall Street firms suffered deteriorating finances, you could have played a role in warning the public of those failures. Instead, it appears you chose to do the opposite, joining those who defended your clients against public scrutiny and criticism.
Bear Stearns failure:
On the day of the failure, March 14, 2008, Moody’s maintained a rating for Bear Stearns of A2, the same rating it had published from June 1995 through June 2003.
S&P was equally generous, giving the firm an A rating until the day of its failure.
And Fitch had assigned Bear Stearns an A+ rating throughout the 18-year period between February 2, 1990 and the failure date.
Lehman Brothers failure:
On the morning of the failure, Moody’s still gave Lehman Brothers a rating of A2; S&P gave it an A; and Fitch gave it an A+.
Other major banks:
We witnessed a similar pattern of complacency with the failures of …
• New Century Financial, which filed for Chapter 11 bankruptcy in 2007;
• Countrywide Financial, which was bought out by Bank of America in 2008;
• Washington Mutual, which filed for bankruptcy in September of that year;
• Wachovia Bank, which was acquired by Wells Fargo by yearend 2008;
• And many others.
Why the Consequences of
Complacency Can Be Catastrophic
In nearly all these failures, publicly available data made the risks evident well in advance. (See Weiss Research study.)
But in virtually every case, rather than protect investors from issuer defaults, your priority seems to have been to shield issuers from investor selling.
And in nearly every case, we now know how catastrophic the consequences have been for investors, for the economy and, ultimately, even for the issuers themselves.
Indeed, if you had not shielded issuers from public scrutiny and selling pressure, they might have acted sooner to bolster their balance sheets.
At a minimum, if you had released prompter, incremental downgrades, you could have given investors the chance to absorb the bad news in smaller doses, helping to avoid much of the shock and panic that ultimately prevailed.
This is why it’s so vital that you downgrade U.S. government debt — before the country is driven over the fiscal cliff.
Factors Warranting an Immediate Downgrade
Of Long-Term U.S. Government Debt
The risk factors justify nothing less:
1. Debts and deficits. In the last few years, you have downgraded sovereign nations with deficit and debt ratios that are equivalent — or even superior — to those of the United States. Specifically,
• S&P downgraded Spain’s long-term credit rating on April 28, 2010 to AA with a negative outlook, due in part to its government debts totaling 59.2% of GDP. In contrast, at that time, the United States government and its agencies had total debts equal to 94.7% of GDP, or nearly 60% more than Spain’s.
• S&P downgraded Portugal’s long-term credit rating on April 27, 2010 by two notches, from A+ to A-. However, in proportion to its economy, Portugal’s federal deficit was actually smaller than ours — 8.3% of GDP compared to the U.S. deficit at 10.6% of GDP.
• Greece, still at the heart of the European crisis, was long ago downgraded by all three rating agencies. But even compared to Greece, America’s deficit/GDP level was only slightly better — 10.6% in the U.S. vs. 12.2% in Greece.
Of course, there are other factors that have prompted you to downgrade these euro-zone countries — such as panic in their financial markets, a sudden disappearance of liquidity for their bonds, and the surging cost of raising new funds. But it is simply not reasonable to wait for a similar disaster in U.S. government bond markets before downgrading America’s long-term debt.
2. Outdated arguments. It appears that you are making special allowances for U.S. debt because of America’s size and stature in the global financial system. However, that argument is largely outdated.
Given the greater role played by bailouts since the debt crisis of 2008, it is the smaller nations that may now have a strategic advantage:
They can usually count on emergency external financing from richer nations or the International Monetary Fund. The United States cannot. There’s simply no other country big enough to bail it out.
3. Vulnerability to capital flight. The United States is the world’s largest debtor nation, owing far more to foreign creditors than any other country, leaving the U.S. vulnerable to capital flight.
Yes, the U.S. has a unique advantage — because the dollar is the world’s primary reserve currency. But that’s a double-edge sword: It also helps ensnare the U.S. into more foreign debts, raising still further America’s vulnerability level.
4. Aggressive central bank action. Among all major central banks, the U.S. Federal Reserve has been the most aggressive in buying up low-quality debt, more than tripling the size of America’s monetary base since the failure of Lehman Brothers in 2008.
This alone should raise serious questions about the underlying stability of U.S. financial institutions, the sustainability of the U.S. economic recovery, and the long-term ability of the U.S. Treasury to fund and repay its debts. (See “Bernanke Running Amuck.”)
More Threats to America’s
All told, as documented by Grant’s Interest Rate Observer, there are many risk factors that you must consider when evaluating America’s long-term credit rating, including:
• The U.S. government remains exposed to trillions of dollars in contingent liabilities from its intervention on behalf of financial institutions during the 2008-2009 debt crisis.
• Mandatory outlays for retirement insurance and health care are expected to increase substantially in future years, with the present value of future expenditures estimated by the Treasury Department at $46 trillion.
• The U.S. Federal Reserve, as part of its response to the financial crisis, may be exposed to significant credit risk.
• The U.S. economy is heavily indebted at all levels, despite some deleveraging in recent years.
• U.S. states and municipalities continue to experience severe economic distress and may require intervention from the federal government.
• Elected officials may not take the necessary steps to ensure long-term debt sustainability and may take actions counter to the interests of bondholders.
• The U.S. dollar may not continue to enjoy reserve currency status and may decline in the future.
• A rise in interest rates could adversely affect government finances.
• Improper payments by the federal government continue to increase despite the Improper Payments Information Act of 2002.
• The U.S. government has failed its official audit by the GAO for 14 years in a row, with widespread material weaknesses found in multiple government departments and agencies.
The case for severe U.S. debt downgrade is now overwhelming.
I challenge you to take the appropriate action now. Any failure to do so can only magnify the risk of the looming fiscal cliff disasters.
Martin D. Weiss, President
Weiss Ratings, Inc.
Weiss Ratings is an independent rating agency, covering 19,000 U.S. banks, credit unions, and insurance companies, with the primary mission of protecting the public from financial risks without bias or conflicts of interest.
Weiss Ratings is the only agency to consistently name — and warn the public ahead of time — of financial failures among S&Ls, insurance companies, banks, and brokerage firms since the 1980s. And it was the first rating agency to issue a low credit rating on U.S. government debt.