In the wake of the S&P downgrade, Scott Sumner featured some comments by David Levey, the former Director of Sovereign Ratings for Moody’s, who during his tenure there wrote Moody’s Sovereign Rating Methodology Handbook. Despite his agreement that the United States’ “long-term debt outlook is deteriorating under the pressure of rising entitlement costs and an inefficient, distortionary tax system”, David argued that we have “extra leeway” due to the “the global role of the dollar and the central position of US bond markets”. I had an email discussion with David about the ratings agencies and his position on the downgrade. A lightly edited version follows:
Adam: Are the judgements you’re making based upon S&P’s recently updated Sovereign Government Rating Methodology and Assumptions, or the guidelines used when you were at S&P? I have only looked at the new guidelines, and I know there was a change made after public comment on proposed rules. So upon which methods are you basing your judgement? And would you say the methodological change is consquential in this regard?
David: Hard to answer the first part of your query, since I was at Moody’s, not S&P. Don’t feel bad about the mix-up. During my working years, even very sophisticated investors would quickly forget which agency had made which rating move and in which order. And any dumb move on either’s part would harm the reputation of both. On methodology, things changed in the mid-2000s. Under pressure from regulators and issuers, the agencies were forced to “open the black box” and become much more explicit about their criteria, scorings, weights attached to various factors, etc. There was a tendency to move to a “scientistic”, quantitative, formulaic approach. I tended to resist that (being a great admirer of Hayek). I saw risk assessment as a multidisciplinary, highly qualitative, judgment process involving a varied weighting of factors. It was not sufficient to assign likelihoods to various risk scenarios in the economic and political areas. The importance of these factors would vary according to each country’s “stage of development” and specific institutional features.
BTW, I never believed that we were somehow smarter than all the other bank/hedge fund analysts doing the same kind of assessment. Our only special claim was that we could be “unbiased” because the company held no financial assets. Of course, that still leaves open all the perverse incentives and “rating shopping” practices that contributed to the agencies’ awful performance in the MBS/CDO markets.
Adam: I also think you’re argument, with a slight modification, is not so different than S&P’s. Here is how I would change your’s to make them consistent:
The bottom line is that the global role of the dollar and the central position of US bond markets make somewhat elevated debt ratios more compatible with a Aaa rating than is the case for other countries, another version of the US’s “exorbitant privilege”. But that extra leeway is finite and serious reforms to entitlement programs, particularly Medicare, must be made in a reasonable time horizon. Given the current deterioration of and divisiveness in fiscal policy, we view the threat that serious reforms are not made in a reasonable time non-negligible.Thus there is a small but significant risk that within the next ten years. global investors will eventually conclude that our political system is incapable of making the needed changes and turn away from US assets, regardless of the institutional strengths of US markets.
How far are you from my edited version of your views? And would this be sufficient for a downgrade?
David: The long-term forecasts for government debt — depending as they do mainly on demographic and medical cost trends — haven’t changed much. We’re just more aware of them and the divisiveness you mention was inevitably going to arise as painful choices got closer and key groups — like the elderly — began to realize what they might be in for. The divisiveness can alternatively be viewed positively as a signal that the intensive social bargaining and political negotiations necessary for a solution are arriving more rapidly than we previously expected.
You say that my argument and S&P’s are not that far apart. No reason they should be. The difference in expected probability of default for a one-notch downgrade near the top of the scale is tiny. The problem is that the symbolic value of a AAA/Aaa makes a downgrade from that level significant far beyond its intrinsic significance. In any case, even with the new wording, I would still total up all the relevant considerations as leaving the US in the AAA category — but maybe not at its very top.
Adam: Felix Salmon characterizes the difference between Moody’s and S&P’s ratings objectives as S&P being only interested in the probability of default, whereas Moody’s is not interested in the the probability of default per se, but rather the expected losses. In addition, he says S&P explicitly does not intend their ratings to be a market signal, whereas Moody’s does. Do you agree with Felix’s characterization of their differences? And if there are differences between agencies in what they intend their ratings to be, is your judgement that S&P shouldn’t have downgraded them based on what they intend their ratings to be, or based on Moody’s intention, or something else?
David: Not an easy question to answer succinctly, but here goes…
I think Felix is wrong. Since S&P has not been as explicit as Moody’s about what their ratings mean, some indirect evidence has to be used. First, S&P “notches” for subordinated debt, meaning that they are taking into account that a default on that debt is likely to have a greater severity than on senior debt. Second, market participants would find ratings almost impossible to use without comparability of meaning. So — in a sense — the markets more or less force equivalence of meaning on the agencies. Third, if the meanings were that different, there would be a lot more “split ratings” (situations where the agencies rate differently) than there are. So, if there is a disagreement between Moody’s (and myself) and S&P on the U.S. rating, it is a substantive one, based on judgments of the likelihood of fundamental reforms to spending and taxation, alongside the financial market characteristics I referred to in my initial statement.
In your comments on Felix’s comments on Nate Silver’s comments on S&P’s decision, you make a point which I think is only half right. You say that sovereign defaults “are always political, rather than economic” and that “A sovereign credit rating is therefore primarily a function of a country’s willingness to pay, rather than its ability to pay.” The truth, however, is more complex. Neither willingness nor ability can be defined independent of the other. “Willingness” depends on political calculations of the degree of sacrifice that would be required to make payment, which in turn depends on the financial resources available or easily raised. “Ability” depends on how much additional resources for debt payment the government can “squeeze out” through reductions in spending or increases in taxation — a political consideration. So the relation between them is -to use an old phrase-”dialectical” and the analysis is based on what Adam Smith called “political economy”. This may sound like “scholastic” nit-picking, but the point is vital for guiding the rating decision process.