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Dr. Strangeloan, or How I learned to Love the Bond and Not to Worry

I would like to tell you about the recent Unites States long-term credit rating downgrade by S&P.

Now surely, the Republic will stand regardless of the doom and gloom the S&P minions may see in their crystal ball. Rather than piling in right away with Hegelian negativity on steroids, please allow me to indulge in one of my most cherished childhood memories. Beware, though, for I’m about to tell you a cybernetic story, so if you have better things to do right now, please stop reading. Despite my best literary efforts, what follows is likely to be about as exciting as reading the Wall Street Journal, although Rupert seems, of late, to be doing his best to “raise the bar,” so to speak.

Many years ago, I was addicted to a TV show called Kung Fu. It was a typical 60-minute weekly drama set in the old American West and relating its myths, lies and fantasies. The hero (David Carradine) was presumably a Chinese immigrant whose early childhood had been spent as a pupil at a Buddhist monastery somewhere in China, where he had received extensive training in self-control, martial arts and philosophy. He was kind and merciful and would spend approximately 55 of the 60 episodic minutes preaching peace, understanding, self-abnegation and friendship among men of good will. He would then spend the remaining five minutes beating the living hell out of everybody else on the show. The moral of the story, at least it seemed to me at the time, was that in some cases peace and love just don’t cut it.

The episode I most vividly remember is one during which two young novitiates, one of whom (Cheng) is our hero, the other (Chang), are given cash to travel to a nearby village to buy food for the entire household. On the way, they encounter a nice-looking old man who inquires about their journey. They tell him the truth, as young boys are wont to do, whereupon he proceeds to tells them about a secret shortcut to the village that will save them about half an hour. They thank him and happily take the shortcut. Unfortunately, this was a con job. In the middle of it all, they fall prey to an ambush and lose the cash. They return to the monastery, clearly with their tails between their legs, and are immediately asked to join a woodshed meeting with the Master in residence. It went something like this:

Master: Tell me, Chang, what did you learn from this?
Chang: Not to trust strangers!
Master: Tell me, Cheng, what did you learn from this?
Cheng: To expect the unexpected.
Master: Chang, you will be leaving us soon.

And the rest, as they say, is history. Why am I telling you this?

For openers, let me tell you why I am not telling you this. Not because I expect you to spend your early years in China learning martial arts and philosophy at a Buddhist monastery, and not because I think violence is an acceptable way to resolve problems, for it obviously is not. On the other hand, even if you did hang out in Chengdu for the next ten years, you would probably not even miss a beat on Wall Street, and would most likely be able to resume right where you left off. Voltaire said, plus ça change, plus c’est pareil: The more things change, the more they stay the same. Can a Frenchman really be totally wrong, especially a self-maid man? But no, I have a more mundane goal in mind today, one I already warned you could only be reached indirectly and painstakingly.

Are you still with me? Please don’t quit now, for the worst is yet to come.

The world of credit ratings does not exactly connote Hollywood-style sex appeal. Historically, the average credit analyst was usually someone with a social profile lying half-way between a misfit and a nerd, very much like me, I’m afraid, going about his business with the naïve certainty that the world is better off because he exists, defending the human rights of widows, orphans, institutional bond-fund managers and other defenseless creatures. When the alternative is something as profoundly rewarding as clearing & settlement or custody, one can easily understand the attractiveness of a job in which recognized business leaders actually return your phone calls and call you by your first name, apparently because deep down, you’re such a pal. If only it were true. The only occupations with more ego-stroking potential are probably journalism, movie stardom and fashion design.

With the advent of structured finance, though, a market solely predicated on the existence of primary market ratings and thus, on the prior possibility of value, credit analysis acquired an exalted, quasi-mythic status, the moral equivalent of the Oracle at Delphi. Ordinary mortals with ordinary jobs had suddenly been made into rock stars. A formerly inconsequential human being was now referred to as a Bodhisattva, while invitations to Louis Vuitton cocktail parties were no longer unthinkable, or infrequent. Credit analysts went from limp losers to Latin lovers in one easy step, and their financial exploits were now recounted in hushed and respectful tones. Their new issue reports got more web-views than Paris Hilton, and seven-figure salaries went from unattainable to lived experience. At Midas Mufflers, you were just a “somebody,” but at S&P, you, erstwhile unacknowledged toiler of the netherworld, had suddenly turned into a big swinging you-know-what, literally a general of the capital markets. Now clearly, every man is a general to his dog, hence the popularity of dogs.

Is this not the quintessential American dream, the faint but still non-zero probability that every US citizen can one day become a hero and marry a fashion model? What’s wrong with a little Yankee self-actualization, with getting that proverbial piece of the action? After all, isn’t it true that no man is an island, in itself entire? Apparently, reciprocity is the key to every lucrative relationship. So, cooperation with Wall Street was obviously the right thing to do.

What’s wrong, of course, is that it was just that, a beautiful dream.

One day, you had to wake up and realize that, when all is said and done, you never understood a thing about finance, that Warren Buffett is not really your high-school buddy, and that the captain of the swim team is still more likely to wed the fashion model you were ogling so fondly just a few moments ago. At some point, it had to dawn on you that you never were the master of your own power; that you commanded without authority, attempting to live your life in reverse. In the end, you were still just who you had always been, only less so because you actually believed the dream. If only investors would forgive your trespasses while punishing those who trespassed against you, all would be well in the quiet countryside, to say nothing of the not-so-quiet Countrywide.

Mea culpa, mea culpa, mea minima culpa!

Dear repentant credit analyst, finance is an analysis of time, of non-linear time that is, i.e., of something apparently beyond your ken. Mind you, the same type of fiasco would have happened had anyone else been in your shoes. Wall Street bankers, self-proclaimed former masters of the universe, are actually glad they have someone else to blame but themselves, for the truth is they would have done exactly the same thing, and most likely worse, given that the average investment banker has as much self-control as Bill Clinton at a Playmate convention. As that famous playwright would surely have said, “The fault, dear trader, lies not in your deals but in yourselves.”

But wait, say you, what about the S&P downgrade? I know what you’re thinking right now. “Can’t this guy say something nice for a change? Can’t he say something righteous, and loving? These are beautiful people!” In the end, isn’t it just easier to shoot the messenger simply because you don’t like the message? Ah yes, the downgrade. What about it? Essentially, S&P said there is too much politics in Washington, and that $2.4 trillion is not enough; it needs more. I’ll bet Monica Lewinski said that too.

First, to say there is too much politics in Washington is like saying there is too much “greed” on Wall Street, too much reckless driving at the Indy 500 or too much sex in a brothel. This shocking news is neither shocking nor news. Second, just a week ago, S&P admitted publicly that it had a bug in its CMBS rating model, most likely for the past 20 years or so, and canceled all future CMBS deal ratings until further notice. Goldman was impressed I’m sure. But that’s not the best part. Just a few months ago, it also admitted not understanding the waterfall-distinction between pro rata and pari passu. I guess S&P can speak neither Latin nor Excel correctly, which may go a long way towards explaining its reluctance to rate Latin American countries AAA. On its face, this downgrade-thing is chutzpah taken to the limit, akin to a priest downgrading God, or a husband telling his wife, “Honey, this time I’m putting my foot down!” Basically, it’s a joke on many fronts.

On the political front, S&P no longer has the moral authority to downgrade an entire country after the fact, when this is precisely what they are accused of having done, no doubt coincidentally by that very same country, just a couple of years ago. If anything, the downgrade is way too late, not to mention way too smug and convenient. In a self-respecting sport like football, late hits will get you a big fine. What will this get S&P? God knows! But that’s the whole point, gentlemen. God is now dead, and S&P is responsible.

A famous Russian proverb says: После боя кулаками не машут. Don’t swing your fists after the fight. When it’s over it’s over, guys.

Perhaps S&P ought to use its credit-rating principles on itself and apply its outrage at the nefarious influence of politics to its own pathetic situation, contemplating the countless lawsuits it is now defending, suits that arose directly as a result of S&P’s mammoth incompetence and inability to know when to downgrade something much less problematic to grasp than Beltway politics. Yes, it is wrong to shoot that oh so Standard, but decidedly not Poor, messenger arbitrarily, but this is someone who’s been walking around for years with a bull’s eye on its forehead.

On the technical front, the thorniest issue is the fact that the US credit rating is the ground, the basis of all other ratings, the equivalent of zero in mathematics. Moving the zero on the scale, apparently without a Plan B, makes as much sense as switching from Fahrenheit to Centigrade in temperature reporting, and then claiming it is “colder” in New York this summer. At this juncture in world history, please tell me who is more creditworthy than Uncle Sam? Do they have nuclear weapons? Do they have cruise missiles? Do they own the Internet? Does their currency also count as international money, in addition to gold? Viewed in the proper context, the S&P downgrade is a meaningless, exculpating, cynical and naïve move that can only result in the immediate focus of the nation’s attention on how badly these people behaved, and continue to behave, despite clear pronouncements to the contrary and innumerable acts of contrition. A savvy US president once remarked that if you’re not part of the solution, you must be part of the problem. Sadly, S&P seems to have crossed that thin red line.

The last bump on the road to righteousness in this S&P saga is likely to be the inconvenient fact of the sovereign ceiling. As you all know, no corporation can have a credit rating higher than that of its sovereign for the simple reason that the sovereign has an implicit, if not explicit call on its country’s assets via taxation and other legal mechanisms. So far, no one has denied this. Therefore, in a few days or so, S&P will have to either downgrade every American AAA-rated corporation, presumably telling them they are sorry, because to such companies a downgrade is not just politics, or else do nothing, thereby covering itself with additional vainglory and demonstrating once again that it is better to remain silent and pass for an idiot than to speak and prove it.

Finally, what about Chang and Cheng from Kung Fu?

You will recall how Chang was fired from the monastery for failing to understand the principle that whatever happens to you should not always be ascribed to others, and that taking responsibility for your own actions and their consequences is the origin of all wisdom, not to mention of all wealth.It is painfully obvious to most observers that S&P needs to take a good look in the rear-view mirror and ask itself, in addition to the army of lawyers now on its payroll, whether it still likes what it sees, or whether, as most of us have already concluded, this sad reality-TV episode wouldn’t be a great excuse to spend some time in a Chinese monastery. From what I know of S&P analysts, I think they might just love it. And who knows, China might begin to love them back!
In regard to the implicit call a sovereign has on the assets of it constituents...
Does that idea fully describe the liklihood of a nation not honoring its bonds?  Russia defaulted in 1998; was this after having taxed its citizens to a maximal amount?
Also, is it imaginable that the citizens and companies belonging to a sovereign could leave the country in troubled times before such a call is exercized?
Thank you for the entertaining article.
The US will default, for sure, a fact! maybe not now, maybe not in 3 years or even longer, but it will default. Why? because they can't cut spending anywhere near the levels they need to, and they will just keep on borrowing and borrowing. Its pure madness, hence the S&P where totally right to downgrade them.