The U.S. Credit Rating Downgrade: What Does it Mean?

August 9, 2011

JULIA KENNEDY: Welcome to Just Business, a series of interviews on global business ethics. Today I am talking about financial crises past and future with Ann Rutledge, founding principal of R&R Consulting.

From Rutledge's career at J.P. Morgan Securities in Asia, Moody's Investor Service, and as an adjunct professor and media expert on credit ratings, not only does Rutledge understand the technical side of the global economy, but as a consultant, she examines reforms to inject more accountability into the global financial system.

Ann Rutledge, welcome to Just Business.

Thank you, Julia.

JULIA KENNEDY: Let's start with the basics. A couple of years ago, informed Americans had to learn about credit default swaps and all kinds of other technical terms. Now we all have to learn about international credit ratings.

Why don't you first boil it down for our audience, and then we'll get into some of the analysis.

Credit rating is an arm's length, supposedly an arm's length, objective valuation of the credit risk of a bond. It is a kind of standardization of risk measurement.

If we look back to the old days when the banks were the primary source of debt capital, banks treated each loan as an individual case and made loans and priced loans and wrote covenants based upon the analysis of the individual borrower.

That market is long gone. First of all, in the 1970s the bank market for lending gave way to an investment bank model where banks were originating loans but not necessarily carrying them on their balance sheets. It was a much bigger, much deeper, much more superficial approach to credit analysis. Necessarily, it had the need for wholesale treatment. So a credit rating is really the wholesale grading of bond exposures and loan exposures.

JULIA KENNEDY: So then how do you talk about that for a nation?

Right. Nations borrow money, too, and so the U.S. Government, as a user of capital, as a borrower, has its own credit rating. The significant of the U.S. credit rating downgrade from AAA, which is the highest possible rating, to AA+ means, on the one hand, that the United States is not a pristine borrower in the eyes of S&P [Standard & Poor's].

It also means, perhaps in a more abstract sense, that the United States is no longer the center of the economic universe. That I think is the basis for a lot of the controversy, more than the question of the United States' borrowing ability.

JULIA KENNEDY: So the S&P kept a AAA rating for countries like Austria, Australia, and the UK. Do you think that suddenly investors are going to jump ship from the United States and invest in these other countries?

I doubt it very much. First of all, I think that this is a very special market. The investors in sovereign debt are either other countries that are managing pension money, et cetera, or they are speculative traders who play on arbitrages, differences between what they think the sovereign debt quality is really like and what the rating says, no different from any other market. But the U.S. Treasury was considered to be money good or as good as gold by many investors.

So if any of the investors were to begin to suddenly shed their investments, that would actually roil the markets because it would catalyze changes in prices; it would destabilize the markets in a very profound way.

JULIA KENNEDY: So even if this is just sort of a symbolic signifier, let's go back to your earlier comment that this may mark the United States moving from the center of the global economy. Is this a step in that continuum or is there any remedying of that at this point?

It's a step in that continuum. Now I am going to get a little bit professorial if that is all right.

JULIA KENNEDY: Okay, sounds great.

ANN RUTLEDGE: Because there is the social and the economic myth. It's a reality but it's also a myth, right? The U.S. economy is iconic. It dominates other economies.

The United States is a leader in ideas. The United States is a leader in financial concepts. Finance itself developed around the idea of a risk-free benchmark, which the U.S. Treasury was.

A lot of the conceptual bugs, shall we say, with financial theory and the way the financial markets have worked in the last ten years are a reflection of this overstated emphasis on risk-free pricing. Everything in the financial markets is based upon the concept of a risk-free obligation. But that's a myth.

So, in a very interesting way, the U.S. Treasury being downgraded by one notch by S&P shifts everything. Like the transition from an earth-centric to a sun-centric approach to astronomy, we are now moving towards a more balanced—but very different kind of balance—more balanced approach to looking at risk.

The lesson here—and it's very important economically—the lesson is that credit-risk measurement is a necessity. Credit risk exists everyplace, and it has to be measured. The reason why that is so powerful in the context of the U.S. downgrade—mythical, if you like—is because the U.S. bailout of its financial system was really created by this wrong idea of finance in the first place.

JULIA KENNEDY: Explain that a little further. So now you're connecting us back to the last financial crisis, right? How is this almost an outgrowth of that?

In my view it is an express outgrowth. The last financial crisis was based upon a manipulation of the capital markets by the largest players, who followed the so-called market-value theory, which says a price equals a value. How do you know the value of something? You look at its price.

Well, that works for things like the price of corn, the price of coffee, the Starbucks that you drink in the morning, the suit that you put on, but it doesn't work for debt, because a debt obligation is contractual. You have certain payments that you must make, and they are very clear, and if you don't make them, you can be taken to court.

So the best way to value a debt is not based upon what investor A or dealer B says it's worth but an actual financial calculation based upon statistical analysis of the probability of default.

Now, it's not perfect, it's not certain, but it is the closest approximation to value. So when you have the big dealers making prices on debt, they can sort of make it up as they go along.

JULIA KENNEDY: I'm trying to think of an analogy that a lot of consumers might be able to draw, and it sounds like it might fit with residential investment on a home. You buy a home at a certain price, and then if you want to sell it, you have to have it assessed.

That's correct.

JULIA KENNEDY: So the value of that home, regardless of the price you bought it at, changes. So you're suggesting you need to do that for these other debts?

It's very similar. But that's a good example, because many people actually have blamed the housing market on the subprime crisis, when in fact what really happened was the inverse of that. Banks decided how much money they wanted to make from a trade, and based upon that, you could work back to how much the house should cost in order for those transactions to take place.

You must realize that if the price of a house goes up, you can make maybe two trades instead of one trade, and the trade looks much more favorable than it actually is.

So this is a market-risk issue. But, ultimately, the borrower has a limit to how much they can pay. If the price of the house is beyond their means and the cost of the loan is beyond their means, it doesn't matter what the investment bank needed. What matters is whether the borrower can pay or not. That is something that can be measured incrementally.

JULIA KENNEDY: So we have this issue with credit pricing being off. Then what happened? How did that escalate into what we're seeing today?

Right. Well, when credit pricing is off, then the system is off. I would like to again start at the other end, which is if the financial mechanisms are slanted towards the profit making of one party, particularly the party that controls capital, the biggest problem is that that capital cannot find its way back into the economy.

So if a borrower who is working for his own company or working for a small/medium-size enterprise who has limited capital to pay the mortgage cannot pay the mortgage, then the business is in trouble, the employer is in trouble, everybody is in trouble. But not only that. If the bank finds it easier to make a loan to the borrower as a borrower for a home than as a borrower for a business or to make a loan to a small/medium-size enterprise, then these economically productive and positive activities are highly constrained.

So now you see the problem. The bigger problem that underlies the subprime crisis was that capital was being retained in the financial economy, but it wasn't going back to the real economy. And because it couldn't go back to the real economy, the United States had terrible structural economic problems.

JULIA KENNEDY: Now, we had these structural economic problems. After the crisis, what happened? Why didn't we fix them?

We didn't fix them because we haven't acknowledged them yet. President Obama explained the S&P downgrade as a reflection on the political process but not a reflection on the credit of America. Well, politics and finance are intertwined, and if the decision makers, the policy makers of America cannot decide how to resolve the issues, then the money is not going to flow, because the policy isn't clear.

Should we tax in order to make the money flow? Should we cut taxes in order to make the money flow? Or should we address the deeper structural problems? Why should we do that? They haven't been addressed yet.

JULIA KENNEDY: So how would you suggest we restructure the economy to take out these imbalances?

We still remain in a pretty profound state of denial about what happened. I think that the first measure would be measurement itself, to go back and see just how bad the problem was. Where did it originate? In order to understand what our future liabilities are from the financial system standpoint, we need to go back and actually measure how bad the losses were. We haven't done that yet.

JULIA KENNEDY: Do you worry that with focus now on the rating downgrade we are going to lose sight and lose perspective on the second-to-last crisis?

I actually think that if we hadn't had the downgrade, we would have not focused on the crisis. There was a lot of concerted denial, a lot of concerted revisionist history that prevented the people who really wanted to know what happened from finding out what happened, because the people who knew what happened never wanted it to get out.

The idea was that if we just wait long enough, then eventually we'll grow out of the problem. That's the theory. But that's only true if we have an economy that's producing. If we don't have a productive economy, the limbo state could go on forever, but we would still have the myth that the U.S. economy is fine because we have a triple A rating. Everything is just the way it was. It's the same U.S.A. that we've known and loved since the end of the war—I mean World War II.

But that is not true. So I think, in some very interesting sense, the buck stopped at the rating downgrade.

JULIA KENNEDY: So you see an opportunity here?

Absolutely. I see a very big opportunity.

JULIA KENNEDY: And how optimistic are you that we're going to take it?

I am actually very optimistic about it. The reason I am optimistic is because, fundamentally, I do believe in markets, but I believe that the most important role of a market is to communicate information. I care less about pricing. Pricing should follow information. Pricing should not suppress information. We've had a tremendous amount of information being suppressed. What I see now is an opening up and an opportunity for the markets to really assess value in a more authentic way.

JULIA KENNEDY: How can the markets be more transparent? And what can be done to improve even communication? I think a lot of borrowers and consumers sort of claimed ignorance in the last financial crisis. So how can that communication be improved?

I think there are a couple of things. One thing is probably the biggest factor is the fear factor. I know a lot of really smart people who are good thinkers who just turn a blind eye to finance, because they say, I don't understand it, it's dirty; I can't fathom my way through it; just don't get me involved in it.

JULIA KENNEDY: Give me a trustworthy person and I'm going to hand it over to them.

That is exactly right.

JULIA KENNEDY: Be it Bernie Madoff or whoever.

That is the problem, is that the people who understand how finance works live in a very different culture. They may be nice people when they go home, but what they do at work is mercenary because that is the culture of finance. It is specifically the culture of finance in a world where you believe that there is something called risk-free arbitrage. If you believe that there is a risk-free trade to be made, then you must take it, because it's the best trade for your institution and you work for your institution.

The damage comes from trying to create an illusion of risk-free trades when in fact every trade is risky.

JULIA KENNEDY: And you're just pushing the risk on to the next level.

You're pushing the risk onto the person who trusts you.

JULIA KENNEDY: We just covered the consumers which have to take a stronger role in watching what their representatives do for them.


JULIA KENNEDY: How can you improve accountability at the banker level?

I think the banker is the last level because banks have their own mandates. The banks do not exist anymore to circulate capital. That is an idea that stopped when banks stopped lending. I am not saying that all banks have stopped lending, but what I am saying is that the big banks that represent the lion's share of the economy, they don't really lend for a business. What they do is they manage their capital inventories. When you manage your capital inventories as an asset manager, your goal is to maximize profitability. They have no incentive to do it until the incentives are placed upon them.

So what really has to happen at the level of accountability of the financial institution is to separate the function of the financial institution from the administration and the execution—the administrative, the executive and the judicial branches of the government. That will take time because Congress is the person we just talked about, the person who is looking for a trustworthy party.

JULIA KENNEDY: Right. So we have the bankers that are very intertwined with the political system.

Let's talk now about government, which is also a borrower and lender. This gets so complex because government is a borrower and lender itself but is also regulating the economy. So in terms of accountability, it seems like government is the place to go. What reforms need to take place to ensure that it's watching the bankers and keeping its own house in order?

You said a very important thing. It is very complex, because we are a Tower of Babel. I'm not ignoring your government question.

JULIA KENNEDY: We'll get back there.

Okay, good.

There are so many different institutions that oversee the financial system. There are the accountants. There is the SEC [U.S. Securities and Exchange Commission] that looks at securities. There are the bank regulators, and they have their ramifications in insurance and at the state level and so on, and they don't all use the same system, and they don't all have the same degree of sophistication. Even if they did, their agency bias will make them interpret a problem in a particular way. So it is very complex.

JULIA KENNEDY: And their funding may be changing.

Their funding may be changing.

But I think, in fact, one of the most difficult challenges is that nobody really has a common denominator in how they perceive the problems.

I personally am an expert in structured finance. What I have learned from testifying in Congress is that the authors of Dodd-Frank [Dodd–Frank Wall Street Reform and Consumer Protection Act] did not understand securitization, and yet the rules that they put in place now must be embraced by the securities regulator who, by the way, does understand securizations perhaps uniquely.

I am not sure if the bank regulators understand it or not because they are closely aligned with the interests of the banks, who do understand it but had a different interpretation.

JULIA KENNEDY: It's so funny listening to you because what you're saying echoes to me a lot of what we heard after 9/11, frankly, in terms of bureaucratic communication and miscommunication.


JULIA KENNEDY: So perhaps a possible answer would be to throw the kind of funding that was thrown in the Patriot Act to try to open up lines of communication between these agencies.


JULIA KENNEDY: I know this is kind of out of left field. I am just brainstorming here.

No, no. It's an interesting question. But it reminds me of an asset manager who said, "I get paid $2 million to manage the portfolio, but if you want me to be honest, you'd have to pay me a lot more."

So I actually think that what needs to happen is the impossible. Call me a Pollyanna, but I think that people have to make a decision of whether they represent themselves or they represent the good of the country, because everybody now knows how to feather their own nest. Everybody who is a decision maker knows how to maximize the profit opportunities that come from their role. The real question is, is that what they want to do with their lives?

So if government wants to think, maybe for the first time in 30 years, about good government in a utilitarian sense where everybody benefits, there are some fairly simple solutions. But I don't think that they'll happen overnight.

JULIA KENNEDY: What would be the sort of good-government solutions that would come from an ethical, if I may use the word, place?

I think the word "ethics" implies a transparent and fair, level playing field. The way to achieve that, quite honestly, is technical. So if you have the stomach to hear a technical explanation, the technical explanation is to not start at the big-picture level, because the devil is in the details. The technical answer is that you need to agree as a country what AAA really means, because it doesn't mean us. We're human, we're greedy, we're fallible. Nobody is AAA in the true sense, the permanent sense.

So in my field, in structured finance, there is a numerical definition for AAA, and that should be publicly known. Everybody should know what AAA looks like as a debt. Then everybody should know what AA looks like, A, BBB. This is particularly true in structured finance. It is more true than in corporate finance, because in structured finance you are allowing corporations to go to the markets the way a bank goes to the Federal Reserve to get money. It actually changes the velocity of money. It changes our macroeconomics profoundly. So we need to understand, we need to all agree what AAA means.

JULIA KENNEDY: It sounds like part of what you're saying is we need to be more responsible, we need to think about good government and governance, but also we need to be less lazy.

We need to be less lazy. That is true.

Since the subprime crisis originated in the structured finance market, I think we need to understand what structured finance is. Before we decide that it should go away, we should really think twice, because if structured finance is done properly, it actually is a solution to our economic problems, and it is one that the Democrats and the Republicans could agree on.

JULIA KENNEDY: How so? Explain it to me in simple terms.

In simple terms, if we measure our risks, if we measure the risk of the capital that we put at work for the economy, and we have a good risk measure, and we continue to measure it, we can actually borrow more money against the cash flows that come out of the things we invest in.

If we know what the investment in education means in real economic terms, if we know what the investment in a road means in real economic terms, if we know what the investment in housing is, we can actually put that knowledge to work for us by creating a balance sheet where the certain repayments can be funded in debt and the rest of it can be funded by the government or by Bill Gates or somebody who believes in the importance of that investment.

But many of our investments are self-sustaining. We should know what those assets are. That does mean we have to be less lazy. It also means that we need to be a little bit more numerically attuned than we are.

But it honestly does not require a great deal more effort. What it requires is a paradigm shift and an optimism. There really are very good, clear answers out there, but we cannot get so caught up in our fears and so obsessive about what has happened in the past that we think there is no future. There is a future.

JULIA KENNEDY: Are there other countries that do better on these kinds of assessments?

No, there aren't. Securitization and structured finance were invented in the United States, and the United States is still the leader in ideas. It has to come from us.

JULIA KENNEDY: Fareed Zakaria and others have been predicting a "post-American world." That's the title of Fareed Zakaria's big best-seller, and he just came out with Post-American World: Release 2.0. We've been hearing about declinism since Paul Kennedy in the 1980s. So this is a picture in which the United States ceases to occupy the center of the global economy.

We touched on this earlier, but I'm curious if you think that is going to happen. Is that an inevitability, or is there an opportunity for the United States to continue? Should it try to continue?

Well, Julia, I think that I agree that the United States doesn't occupy the center of the world in many respects, nor do I think it should. But the real question is a question of leadership and progress and the future.

I spent 11 or 12 years living in Chinese-speaking Asia, and I have some amount of cultural perspective on where we're strong and where we're weak. But what I see is still a tremendous dependency upon the United States—financially, economically, even if only because we're greater consumers, and intellectually. The ideas still come from the United States. I say that not because I'm partisan but because that's a fact.

So one of the things that I've weighed in my mind about the significance of the downgrade is whether this is China's opportunity to fill the vacuum. My conclusion is that China does have some fiscal discipline that we don't have. But our economy still has more innovation. It's more resilient. It still produces more value, even thought it is constrained, than the Chinese economy does. The world still looks to the United States for its new ideas, the new new thing.

In that sense, in an intellectual sense, we are still kind of the center of the universe, and I think that we ought to think seriously about using our resourcefulness and what we've created, our knowledge of what we've created, to clean up our own house.

JULIA KENNEDY: Tell me a little bit about how you got into thinking in these big-picture ideas, how you moved from the banking world to this consulting analytical role.

I started out in finance as a mistake. My whole generation went into finance, and so did I. It's easy money. You go into an MBA program and you come out and you can make $100,000 more than you could when you went in. You pay off your education in one year and you move on.

Well, it didn't happen that way for me. It did for some of my friends who went to—I went to Chicago. But for me, it took me about eight years to figure out what finance meant.

So maybe I am a big-picture thinker to begin with, but when I started doing structured finance, then—structured finance is really the synthesis of all financial ideas. It's not really a particular method. It's thinking numerically and thinking from the ground up. It's a bit like philosophy, which I minored in in college.

JULIA KENNEDY: Finance is just like philosophy. I love it, yes.

Absolutely, it is. It's the enablement of ideas. It's the organization and enablement of ideas.

So that was the situation when I joined Moody's Investor Service and did structured finance for Moody's, and I did it for four-and-a-half years. Those were great years for learning the craft and also learning about rating agencies. But I left Moody's at the end of the 1990s because I saw that there were issues that they weren't addressing that really needed to be addressed for the securitization rating system to work properly. So that's how I got into it.

JULIA KENNEDY: What do you want to see happen with the financial system and with the federal government to address these issues?

You know, I am not partisan. I mean I have my political views, but I believe in ideas fundamentally.

What I would like to see, first of all, is I would like to see the restoration of the veneration of ideas and practical implementation of ideas that represented American culture at the time that I was born. I would like to see that. I would like to see the restoration of America as a place of much more equal opportunity, where people are rewarded for hard work and good ideas and risk taking.

My belief is—perhaps it's only in my head, but my belief is that what we are facing right now is the end of a 500-year cycle, a cycle of looking at finance through the eyes of corporations. I think what has happened to finance is similar to what has happened to the sciences, that we've drilled down from megastructures to macrostructures to microstructures. Securitization and structured finance is a microstructural approach to finance that conserves capital and rewards effort in a much fairer way.

So I think this is the overall general trend of where finance will go. What I would like to see is I would like to see America embrace that and carry it out and restore itself in the process.

I believe that when the clock was introduced, it revolutionized the concept of time. For the first time, we could measure quality of time in economic terms. What the rating system that we have right now attempts to do is to quantify the quality of capital that we produce.

I think it is inevitable, if we want to continue to flourish as a society or as a globe, that we look more seriously at the quality of capital that we're producing.

JULIA KENNEDY: So it's a matter of learning to use the tool?


JULIA KENNEDY: Well, it's wonderful to have a philosopher/financier on this show. Ann Rutledge, thanks so much for joining me.

Thank you, Julia.

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