What Does Moody's Downgrade Warning Mean?

Includes: BSC, C, DIA, MER, MS, QQQ, SPY
by: Max Fraad Wolff

On January 10, 2008, Moody's (NYSE:MCO) signaled its belief that the long-term credit rating of U.S government debt might have to be cut/downgraded -- below AAA. The firm was clearly neither downgrading nor about to downgrade in the foreseeable future. It was a warning about pension costs, healthcare costs and the track our government is on. I would urge you to take this announcement to heart for three reasons.

First, this is a serious warning about the long-term health and standing of the U.S in the community of global economies. Second, Moody's has provided us with another symbolically powerful milestone. Third, this warning foreshadows looming political battles. We have overspent and face retrenchments. This means struggles over what to cut and whom to stick with the bills. The terrible retail numbers of the Christmas season, fire sales of leading U.S firms, a sliding dollar and falling asset values -- homes and securities -- are all urging in the same direction. Economic downdraft and increased struggles over how to spend remaining funds will be the order of the day in households, legislatures and boardrooms.

What does a downgrade warning statement mean? Moody's is one of the three dominant research and ratings firms that monitor public and private issuers of bonds and stock. Thus, Moody's rates the quality of the IOUs -- bonds -- sold by governments around the world. At the present time they rate the credit quality of government bonds sold by 100 nations. Moody's has rated U.S government bonds since 1917. Since 1917 we have been awarded the highest rating there is, AAA. Many developing countries have fought and struggled with ratings downgrades over past decades. This is no minor matter.

Debt ratings affect the ability to obtain credit, the size of the interest rate and the amount of credit available. Credit ratings signal the safety level and success of a nation's economy. Downgrades -- even warnings of possible downgrades -- tend to rattle investors and reduce business confidence. Trouble is usually close on the heals of warning and downgrade. A U.S downgrade would be disastrous. An oficial downgrade is very, very unlikely. However, there is much worth pondering.

The first reason you should care about the statement is purely economic. America borrows billions of dollars a day from the rest of the world to keep her economy going. We import between $53 billion and $63 billion more than we export each month. This gap is filled by borrowing and selling assets. This is occurring at a fever pitch lately. Foreign entities inject tens of billions per month into government bonds, home mortgages, stocks, bonds and loans.

Lately, Middle Eastern oil exporter sovereign wealth funds and East Asian export surpluses are channeled -- by the tens of billions -- into leading US Financial institutions. Anyone who exports oil, or goods and services to the U.S, ends up with dollars. The more they sell and the higher the price they get, the more dollars they end up with. America runs huge, persistent and rising trade deficits with oil exporters and Asian goods producers. Oil prices have been rising fast. Huge pools of dollars have built up in state administered accounts and been channeled into international investment funds, sovereign wealth funds. On Tuesday, January 15, 2008, we received the announcement of $22 billion more being invested in Citigroup (NYSE:C) and Merrill Lynch (MER) by these sources . According to the most recent available data from the U.S Treasury Department's TICS System, across September and October 2007 foreign entities were net purchasers of $76 billion in U.S government debt. This means that foreign entities purchased $76 billion in claims on future tax collections or asset sales by the American Federal Government. Across the same two months, foreign entities were net purchasers of $26.4billion in Agency bonds -- largely U,S government supported home mortgages. This largely means that billions of dollars in mortgage payments will be collected and sent to the foreign owners of our mortgages. In September and October 2007, we were net sellers of $39.2 billion in corporate bonds .

This can be seen as a series of promises to repay loans with interest from the future earnings of American corporations. Last but not least, America net sold $32.8 billion in stock to foreign holders across September and October. Stocks represent ownership in U.S corporations and claims on possible future dividend. All of the above is sold to keep the international financial markets functioning and the US economy moving forward. We need more money to continue purchasing and they are left with more dollars than needed or wanted. We borrow and sell to get access to spending power and they loan or buy to preserve their position. Thus, the rating and perception of American assets are no minor matter. The holes opening up in U.S books are requiring greater and greater foreign capital to spackle over. There are no free repair jobs. All this money comes with strings attached and returns required. Downgrades make money harder and more expensive to come by. It is neither cheap, nor fun, to be downgraded.

Over the last several years, U.S assets have inflated. Over the last few months this has run in reverse. In many cases other regions were inflating faster before July and are deflating more slowly now. America's assets are almost universally priced in dollars and dollars have been declining against most other currencies. This acts to further reduce the international relative performance of U.S assets. Declining dollars and lagging asset price inflation downgrade our market returns.

This brings us to number two. We have reached milestone dependence on foreign wealth. East Asian goods exporters and Middle Eastern energy exporters have been pumping vast sums into our economy and into leading financial firms. Citigroup, Merrill Lynch, Morgan Stanley (NYSE:MS), Bear Stearns (NYSE:BSC) and others have received tens of billions from sovereign funds directly and are actively seeking more. Governments of potent net exporters sit atop $3-$5 trillion in assets. This is being deployed to increase their returns and assure their positions in the global economy.

Lately, this means the money is used to rescue and purchase influence in leading U.S financial firms. By extension, these purchases extend -- at very least the possibility -- of broader influence in the U.S. Part of being in a downgraded position is the increasingly intense hunt for foreign money and favor. Again there is no free repair service.

The East Asian exporters and Middle Eastern funds allocating tens of billions of dollars into distressed and declining value US firms are not motivated purely by an urge to help. Recent past investments have returned huge losses. We can assume they are knowingly taking risks and throwing good money after bad. You can be sure the guiding intent is not benevolence. We are not guided by good will when our monies flood into their economies.

Thirdly, these developments and the weakening state of economic affairs, beg a series of political questions that are likely to shape debate and decision for the next several years. What is given in return for all this investment, purchase and borrowing? I am not arguing against these actions, I am asking what are the costs? Be assured, there are costs. The past few months have seen foreign wealth funds pour tens of billions after tens of billions of dollars into U.S firms. All the while they must have been experiencing huge losses on dollar investments and past purchases.

Major exporters and oil producers have needs and wants from U.S firms, consumers and government policy. Interdependence grows with diversified ownership and our presently profound ownership. Floods of needed cash by distressed firms and trillions in assets owned intertwine the interests of far flung owners and lenders with firms and others in the U.S. Our monies and credits have been deftly extended around the world with plenty of attached strings. It seems only reasonable to assume this will be true of the wealth now flowing into the U.S. There will be a deep pocketed new player sitting -- in spirit or flesh -- at the boardroom table, the kitchen table and in the halls of state power.

As belt tightening looms, government tax and spending decisions are made, foreign policy actions are debated, free trade is contested; our new partners will be in the mix. Middle East oil exporters have regional needs and issues. Alliances, markets, security arrangements and political realities are in flux these days. East Asian exporters fear free trade lash-back, market access restrictions and external policy meddling. Today's deals and credit could influence future actions on these fronts. As spending is paired by American state agencies, households and firms, pressures intensify. This creates political disagreements and raises the stakes of debate. Free trade and foreign policy issues are hugely important around the world and loom large in the 2008 election cycle. The risks to change and the return to allies heighten during weak economic times and Presidential Elections. We muddled through the closing months of 2007 by selling our assets at a rate of $87 billion per month in September and October. That rate has risen over the last 3 months.

All this begs a question. Why do they buy? What exactly are we selling? This question should be asked by the citizens of any nation in the age of globalized markets. Suspicion of foreign buyers is not an answer, it is bigoted and narrow minded. It is equally naive to assume that recent purchases are benevolent billions from far off lands.

Disclosure: none

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