The anger is certainly brewing after S&P stripped the United States of their coveted AAA credit rating.  Rather than direct the anger towards the reasons S&P issued the downgrade, most of the anger is aimed at S&P.

I think that so many people have been in denial for such a long time that when S&P actually did what they said they would do, the backlash should have been expected.

S&P Was Not to Blame for the Housing Collapse

I have a difficult time defending S&P (or any of the ratings agencies) after they had most of the mortgage backed securities rated AAA leading up to the 2008 collapse.  They certainly played a role, but others played a role as well.  In 1999, the Republican controlled Congress voted to repeal Glass-Steagall.  Nearly all members of Congress voted for this legislation and it was signed by Democrat Bill Clinton.  This legislation was created in 1933 following the 1929 crash that led to nationwide bank failures.  It was designed to separate investment and commercial banking activities.  As we all know now, the reason the banking system nearly failed in 2008 was because the INVESTMENT losses were so great the BANKING activities could not make up for it.  Where is the anger at both political parties for removing this critical legislation that allowed the banking system to nearly blow up?  

Many people also forget that the Federal Reserve was in charge of supervising the banks and ensuring that they did not have too much risk on their balance sheets.  They constantly ignored the repercussions of the loans they were bundling up and selling as mortgage backed securities.  As the public is just now learning - there are provisions in those investments that if the portfolio does not meet certain covenants, the issuing bank can have the loans put back onto their books.  Bank of America is getting all of the headlines because they are being forced to take back some of these loans or if they refuse, are being sued by the entities that bought the mortgages.  The Federal Reserve either did not understand theses risks or if they did, chose to look the other way.

To learn more, check out our series on the Foreclosure Crisis:

Part 1     Part 2     Part 3

As if being the issuers of these mortgage backed securities wasn't bad enough, some banks chose to begin issuing insurance against default on these products (called Credit Default Swaps or CDS).  Other banks chose to invest their money in the mortgage backed securities.  Most of the banks did all of the above.  The Fed was supposed to be supervising the banks and make sure they did not have too much risk on their balance sheets.  Had the banks not been so heavily involved in these securities (something the Fed could have prevented), the housing collapse would have been relatively mild.  Where is the anger at the Fed for failing to supervise their member banks?

The ratings agencies are not off the hook, but we need to be reminded that their entry into the mortgage backed securities market was fairly recent.  If Congress had not allowed commercial banks to also be investment banks or the Fed had not allowed them to hold mortgage backed securities, credit default swaps, and all of the other derivatives on their books, there would have not been any demand for ratings on these securities.  As it was, they tried to take corporate bond analysts to rate these "Frankenstein" securities.  The assumptions that the actuaries used led to the 'AAA' ratings: 

1. There had never been a year where real estate prices fell across the nation (real estate was local).  Since these portfolios were spread across the country, the risk of a decline in real estate was thought to be slim to none.
2. The securities were broken into 'tranches', where the first few years' of payments went into one security, the next few years in another, etc.  The assumption was that even if real estate did decline, the holders of the first few years' worth of payments would be made whole, thus the "no risk" rating.

Most of the time the ratings agencies were relying on the numbers provided by the issuing banks.  The banks were producing these things so quickly that the agencies couldn't keep up.  In addition, Wall Street banks started throwing their weight around by saying if the company would not rate these mortgage backed securities, they would take their bond rating business elsewhere. 

I can see why some anger should be directed at the ratings agencies, but where is the anger at the Wall Street banks that basically became mortgage factories?  These banks not only caused the housing market to grow at a rate that was not sustainable, but they created the vehicles that nearly destroyed our entire financial system.  Meanwhile, they all took home record bonuses, none of them have gone to jail or had to pay back any of the bonuses they made despite the fact that many of their profits were made via fraud.

(There have been many books written and movies made on the housing crisis.  If you are interested in learning more, I would encourage you to check them out.  Be warned, it will make you angry.  My favorite movie on this topic is Inside Job and my favorite book is The Big Short as they provide a nice overview of the entire problem in terms we can all understand.) 

Hypocrisy in the Criticism

Does anybody else see the hypocrisy in the criticism that S&P is getting?  Whether it is the Wall Street banks, the Treasury Secretary (who was in charge of the New York Fed during the housing bubble -- the branch in charge of supervising Wall Street banks), or our members of Congress, they have no problem criticizing S&P's decision.  This is despite the fact that had all of them not CAUSED the housing collapse, our country would not have needed to spend so much money to fight the collapse.  Our national debt has increased by $4.8 trillion since the beginning of 2008 -- an increase of 52%.  Yet they criticize S&P for pointing out the obvious -- that the U.S. cannot continue to add debt at this pace.

In addition, I find it almost laughable that Congress and members of the Obama Administration have come down so hard on S&P for making an independent decision.  These very same people were quite critical of the ratings agencies for their "lack of independence".  Now that the shoe is on the other foot, suddenly the ratings agencies are supposed to consider how their actions, 'impact the economy,' or 'hurt our country's future', or 'cost American investors trillions of dollars in losses,' or 'cause concerns for our national security.' 

So it seems that the ratings agencies need to be independent except when it hurts somebody's chance at reelection or causes the stock market to go down.

Check out: What does the downgrade mean for your portfolio?

The Reasons Behind the Downgrade

S&P was quite clear in April when they adjusted their outlook on U.S. debt to "negative".  They stated that they would need to see at least $4 Trillion in spending cuts over the next 10 years in order to keep their AAA rating.  Rather than tackling those types of cuts then, Congress waited until the very last second to agree to half of those cuts.  (Where is the anger towards Congress for failing to agree to meaningful cuts?)

Taken at face value, those cuts do little to stop the need for our country from borrowing a substantial amount of money over the next 10 years.

S&P also understands something that neither Congress, the White House, or their critics understand -- the assumptions above use a 5% GDP growth rate over the next 10 years.  There are no provisions in there for recessions, which will lead to lower revenue AND the likelihood that Congress will spend MORE money than originally projected.

For more on our broken economy and how we got here, check out:

30 Years Later

The Grand Experiment

Cyclical vs. Secular

What Happens Without the Pain Killers

As weak as the economic recovery has been I think it's safe to say that we could double the amount of money our country will need to borrow over the next 10 years to $11 Trillion.  To put that number in perspective, our nation's TOTAL debt at the beginning of 2008 was $10.7 Trillion.

If your bank came to you and said that unless you cut your spending by a certain amount they would lower your credit rating would you be surprised if they followed through when you refused to cut spending?

The Real Reasons Behind the Downgrade

There was much more to S&P's decision than the lack of real spending cuts that were agreed to in principle as Congress raised the debt ceiling.  There are two key things S&P is worried about:

Entitlements

In the whole scheme of things, entitlements (Social Security & Medicare) are much bigger problems than the fact that our national debt has gone from $5 Trillion in 2000 to $14 Trillion now to $20 Trillion (if you believe the Congressional estimates) or $25 Trillion if you live in reality.

Look at how those entitlement promises compare to our current national debt and economic output.

We've reached a point where Social Security distributions will continue to add to our national debt unless changes are made. 

Unless there are structural changes to the program, it will eat away an increasing amount of GDP from now until at least 2032.

We've known this for at least 30 years.  The problem has mostly to do with demographics as the number of people taking benefits is too large for the number of people still working to handle:

Here's another way to look at it.  This is the number of workers per beneficiary:

Now, had our government actually been saving the money paid into the system, it wouldn't be as big of a problem to our country.  Instead, the Treasury department (spends money Congress directs) spent the money from the trust fund and issued IOUs.  That allowed Congress to spend a lot more money than they should have without impacting the budget.  Now that so many people are beginning to retire, it impacts our current budget as the Social Security fund begins to redeem their IOUs.

Political Environment

S&P specifically mentioned the political environment in their statement:

"The downgrade reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges to a degree more than we envisioned when we assigned a negative outlook to the rating on April 18, 2011."

We've witnessed firsthand the past 4 years how inept Congress is at making true reforms.  Politicians from both sides of the aisle refuse to touch the entitlement programs.  Just look at what happens if somebody wants to address the looming problems in those areas.  You begin seeing commercials like:

"Congressman __________ wants to take grandma's only source of income away."

"Congresswoman __________ wants to refuse to pay for grandpa's medicine."

The political backlash is just too severe right now for them to make any changes, regardless of what it means to our future.

Until we see proof that our politicians are willing to make real changes to the real problems, how can we be angry at S&P for worrying about our ability to ever fix the problem?

Is France Really Better than the US?

I never thought I would have to answer that question and for the most part the US is much better off than France.  However, this question was asked on the call with S&P following the downgrade.  Their answer was interesting:

"Unlike the U.S., France has already been making reforms to their pensions by, amongst other things, increasing the retirement age by 2 years.  This has changed the curve of their deficit in a favorable manner."

In other words, because France is addressing their entitlement programs, in this case yes they are better than the US. (gasp!)

Don't get me wrong, France will end up being downgraded probably much lower than the US, but that is due to the fact that they really don't produce enough products that the rest of the world wants so their economy cannot keep up with all of their other social problems.  You also have the issue of all the loans their banks have made to the failed European countries.

Speaking of Retirement Age

Did you know that when Social Security was created, the age you received full benefits was the same as the life expectancy of the normal American?  In other words, the government told Americans, "you are required to take care of yourself up to the time you would normally die.  From there we will take care of you."

The life expectancy now is 78.  Social Security was not designed to support people for 10-15 years, yet that is how it is being used.  Too many Americans did nothing throughout their lives to save for retirement and yet they expect to continue the same quality of life while retired.

I overheard this conversation the other day at breakfast, which sadly, is not the first time I heard something similar:

"My social security check is enough to pay all my living expenses, but it doesn't leave me any money to travel or do the things I really wanted to in retirement.  If I want to do those things I always dreamed of I'm going to have to get a part-term job and that's just not fair."

That right there is reason enough for S&P to assume that our entitlement problems will not be take care of in a reasonable amount of time.

But We Have a Printing Press

The most commonly used argument from people blasting S&P's decision is that because the US has a printing press (to print money) they will never default.  While that is mostly true, it is S&P's job to point out the risks that a given issue has.

Let's walk though the logic.  The Treasury borrows money from you and you give them DOLLARS and they give you a note saying they will pay you interest and principle on certain dates.  The Treasury pays the interest in DOLLARS and when the note becomes due they pay you back in DOLLARS.

Now imagine that the economy has gotten so bad that the Fed is having to print DOLLARS to help pay the bills.  It is pretty safe to say that those DOLLARS would be worth less money than they were when you gave them to the Treasury.  In other words, in REAL terms you are getting LESS money in return.

I would not call that "risk free".  Anybody that argues otherwise has obviously not studied what happens to countries that resort to printing money in order to pay their bills.

Reason to Be Optimistic

I'm actually encouraged at all of the anger we are seeing.  Let's look back at the stages of grief:

The sooner we get through this anger the sooner we can move through the process.  Once we hit rock bottom, maybe then Americans will be willing to address the real reasons American was downgraded.

Another thing that makes me optimistic is the fact that this downgrade brings to the forefront our real problems.  For too long American voters have been willing to believe everything they see in the media or hear from their politicians.  I've always said that we get the government we deserve.  If we choose to let the media think for us, we get into situations like we are in right now.

If instead we educate our selves and become informed voters we can hopefully find candidates that are willing to stand up and address these issues.  I would encourage you to be vocal with your current representatives and if they will not listen to find somebody that will better represent you in Congress. 

I'd also encourage you to forward this article to anybody else that wants to make America better and was upset and embarrassed that our country was downgraded.

America Still the Greatest Country in the World

By the way, while the better part of this article was classic "Mr. Sunshine", I want to end by saying this:

I believe America is still the greatest country in the world.  I do not believe that any other country (except maybe Switzerland only because of their fiscal conservativeness over the years) deserves to have a higher rating than the United States.  It is my opinion that all of those countries that still have a AAA rating (except Switzerland) will be downgraded as they suffer through another world wide economic slowdown.

The debt problems were not created overnight, nor will they be solved overnight.  Once we decide to address our own problems I have all the confidence we will emerge stronger than we were before.

The comments and posts published in the SEM Trader's Blog ARE NOT investment recommendations. They can NEVER be considered as trading calls or advices. If you decide to use the information offered here for your real trading it is at your own risk.

Investing in the stock or bond markets involves risk and may not be suitable for all investors.  Before making any investment decisions you should carefully consider your investment objectives, level of experience and risk appetite. The possibility exists that you could sustain a loss of some or all of your initial investment and therefore you should not invest money that you cannot afford to lose. You should be aware of all the risks associated with your investments and seek advice from an independent financial advisor if you have any doubts.  All investments involve risk including those managed by Strategic Equity Management.

Opinions expressed at www.stratequity.com are those of the individual authors and do not necessarily represent the opinion of Strategic Equity Management or its management.  Any opinions, news, research, analysis, prices or other information contained on this website, by Strategic Equity Management, its employees, partners or contributors, is provided as general market commentary and does not constitute investment advice. Strategic Equity Management will not accept liability for any loss or damage, including without limitation to, any loss of profit, which may arise directly or indirectly from use of or reliance on such information.

The use of this website constitutes acceptance of our user agreement.  Past performance is NOT indicative of future results.