There has been a lot of discussion over the past few days about whether the United States deserves a triple-A rating. The weak and meandering attempts of the Congressional leadership and President Obama to reach a consensus on raising the debt ceiling has prompted this storm of confusion. The political theater is painful.
Most of the talk about ratings revolves around whether the level should be lowered one or more notches. But in The Telegraph today Ambrose Evans-Pritchard goes further and says it’s not really that important whether the United States retains a triple-A because the credit rating agencies don’t have the credibility to strip the rating to the world’s largest sovereign debt issuer (emphasis mine):
Yes, the US may be stripped of its AAA by Standard & Poor’s. A nice one-day story, but otherwise irrelevant. Global bond vigilantes are quite able to make their own judgement on the substantive default risk of the US. The rating agencies are out of their league on this one.
Evans-Pritchard’s statement implies that the qualitative judgments of rating agencies about default risk are less useful than the collective insight of bond-market participants. But is the market rational? The bond markets assess their view of the likelihood of default through a quantitative measures like credit-default swaps. CDS are bought and sold between institutional investors and represent a sort of wager on whether an issuer like the United States or the state of Illinois will default on its bonds. They are a kind of insurance policy because if the issuer does default then the holder of the CDS receives payment of principal from the issuer. In other words, it’s an opinion with a whip in its hand — unlike the assessments of credit rating agencies, whose raters suffer nothing if they assigned the wrong rating.
The CDS market data provider, Markit, sent over some price levels on municipal CDS today that included a price for CDS on U.S. Treasuries. I thought it might be interesting to compare the credit rating of the US (AAA/Aaa) and the corresponding credit-default swaps (in basis points) against some heavily indebted states (see chart above).