Late last week Moody’s Investors Service announced a change in the outlook on US government ratings to negative from stable. This signals that the triple-A rating of United States debt could be lost in coming months.
There is nothing particularly newsworthy in this announcement except perhaps that it took so long for Moody’s to align with the views of the other major rating agencies. S&P Global reduced the sovereign rating from AAA to AA+ during the 2011 fiscal crisis. Fitch took similar action in August 2023. Moody’s did not downgrade the US; rather it warned that a downgrade was likely in coming months.
It is no surprise to those who follow credits even casually that Moody’s cited the combination of rising US debt levels and higher interest rates in impacting debt affordability, and the political risk stemming from a fractured political process.
We’ve noted previously that there is a growing disconnect between the formality of the sovereign debt rating and the reality of its effects on the bond markets. One might think that a negative view of the credit of US government bonds would lead them to lose value. In 2011 when S&P acted volatility rose and Treasury bonds, at least temporarily, lost value in the market. In the first several trading days after the Moody’s action, the 10-year Treasury note actually gained in value as its yield declined by nearly 15 basis points. True, other factors affect bond yields but still. . . ..
Credit ratings matter little (less?) when it comes to sovereign debt of the US. Which leads us to observe that statutes and investment policies that limit public agency investments to those that carry the highest ratings from the major rating agencies are a bit antiquated. Today we might observe that “A Treasury bond is a treasury bond” and leave it at that.
That is not to say that credit is not important. Maybe investors could overlook the rating action on sovereign debt of the US by Moody’s last Friday, but in further rating actions this week Moody’s lowered the outlook for Federal agencies, large US banks and two large life insurers as the rating agency observed “the potentially weaker capacity” of the US government to support them. (Interestingly this analysis did not carry forward to Aaa rated states and municipalities; also this week Moody’s affirmed that the top-rated states were not affected by the change in sovereign debt outlook.)
There is a caution here not to take the strength of Federal agency or corporate credit for granted. These large, complex financial organizations affected by the Moody’s announcement rely in part on real or implied support from Uncle Sam. If the United States is less capable of supporting them, or lacks the will to do so, investors—particularly public funds investors who have near-zero tolerance for taking credit risk—should be even more careful.
The protective measures—avoiding credit investments entirely or employing a strong credit research process and limiting/diversifying credit-related holding-- have costs. There is no free lunch.
Banks in the News Again
The banking industry used this week’s hearings by the U.S. Senate Banking Committee to argue that proposed Federal regulations to raise capital requirements would restrict their business and could hurt the economy.
This is a highly complex issue that affects the plumbing of the US and global economy. (See Beyond the News August 17, 2023.)
What does this mean for public agency investments? Public funds investors rely heavily on banks to populate their investment portfolios. The portfolios may include deposits (some of which are insured or collateralized), commercial paper, short-term bonds and negotiable certificates of deposit. Because of the volume of bank-issued securities and credit characteristics of banks, bank liabilities make up a large portion of the non-government assets of many public funds portfolios.
A bit of context: Banks that invested heavily in long duration assets when rates were low are sitting on hundreds of billions of dollars of unrealized losses. Some banks have also experienced significant increases in the cost of deposits. The regulators’ pitch to the Senate committee was that, while the banking system remains strong, capital bases were weakened by macro-economic events, banking regulations do not fully match the standards of the Basel III regulations designed to promote financial stability in the international banking sector, and the effect of an economic downturn or sustained period of higher interest rates could degrade bank credit.
Not all bank constituents have the same interests or perspective when it comes to the proposed rule to enhance capital requirements. Stock holders of banks would have their capital positions diluted by additional capital raises so they are likely to be disadvantaged by the new rule. On the other hand, larger capital buffers could better protect creditors of the bank—those who have deposits beyond Federal deposit insurance limits, own bonds or notes, or invest in bank-related commercial paper. They could benefit from the rule. And the proposed rule could reduce the cost of bank failures on the markets and on Federal deposit insurance. So stockholders, bond holders and bank depositors may look at the proposed rules differently.
Enhanced capital requirements could lead to changes in lending patterns and consolidation in the banking industry. There are currently more than 4,000 banks. The vice chair of the Federal Reserve, Michael Barr, testified at this week’s hearing that fewer than 40 banks—those with assets over $100 billion—would be affected by the capital rule.
Consolidation is not necessarily a bad outcome for public agencies that invest in bank obligations, as large banks are more likely to offer debt securities in the public marketplace, and public funds investors whose investment appetite is limited to short-duration high quality investments could see more offerings. Larger banks are more likely to carry investment grade credit ratings and their business is more likely to be scrutinized by third party analysts and by the financial press.
But consolidation could lead to less lending in smaller communities and to small businesses. The community bankers fear that the rule, and added cost of supervision, will put them at an economic disadvantage and drag on the economy.
The regulators recently extended the public comment period on the proposed rule from November 30 until mid-January. Barr and fellow regulators got an earful at the hearing from Senators and industry groups are marshaling forces to make their case that the industry is adequately protected by current capital rules.
The bottom line. If you are Jamie Dimon, the head of JP Morgan, it’s clear where you stand on new capital requirements. For others, it depends.