After the last year or so it is a wonder that anyone subscribes to rating agencies anymore but they do. In fact it is headline news when they come out and make tweaks on their outlooks like they did for UK soverign debt on 5/21. S&P revised its outlook for the UK to negative from stables and affirmed the AAA long term rating and A-1+ short term rating. This event makes me think about two things. First (1) The rigidity of the investment community and (2) what do the ratings really mean?
I’ve complained beforethe ability the rigidity of the investment community but the idea is that if everyone is looking at the same analysis the markets don’t function well because everyone wants to sell at the same time. This will happen even if it just a descent sized group of people blindly following ‘guidelines’ about ratings, because the smart investors know that non-economic ‘guideline’ sellers will dump securities with a downgrade occurs and thus don’t buy until that flow is well underway. For those of you who don’t know what I mean by guideline selling it means that a investment manager has a rule about what he can invest in and when that rule is broken he must sell the asset. This creates a very inelastic (who doesn’t care about price) or what I call ‘non-economic’ seller. We should be hoping that no one (the big reserve holder or big custodial banks) have a rule about British debt which would disrupt the markets.
My second question is related to the rating itself. What is AAA mean? Low default risk? If that is the case rating domestic sovereign debt (with a well run finance branch) seems a little odd; worse case it the Bank of England could buy the debt (print the money) and inflation away the debt. (Yes, I’m ignoring what happen to Russia when they defaulted on their domestic debt but the idea that domestic default seems extremely unlikely is true). Note: I’m under the impression that AAA for gov’t and municipals vs corporates are two different scales (you can’t compare across them in a meaningful way only within a group…yes that is annoying). Does it mean low real purchasing power risk? If this where the case then lowering the sovereign debt rating would require the lowering of all other debt (because it would be driven by a macro force: inflation or currency). So as far as I can tell, AAA mean better than AA, which mean better than A and so on. Even ignoring the rigidity that the rating agencies put into the system one would hope we (the investment community) could come up with a better (more meaningful) syntax…like probability of default (let use implied and just get rid of the rating agencies).
