Why the Whole Idea of “Rating” Government Bonds is Absurd

James Kwak at Baseline Scenario offers a great analogy and explanation for why the whole concept of a private rating agency such as Standard and Poor’s putting a credit rating on government bonds is absurd.  It adds no new information.  Now if S&P wants to rate the Greater Podunk Water Authority bonds or some such, that provides a service.  But they add nothing at the national level. James says:

Still, I think the whole thing is preposterous. S&P downgrading the United States is like Consumer Reports downgrading Coca-Cola. Consumer Reports is a great institution. For example, if you want to know how reliable a 2007 Ford Explorer is going to be, they have done more research than anyone to figure out the reliability history of every single vehicle. Those ratings are a real public service, since they add information to the world. But when it comes to Coke and Pepsi, everyone has an opinion already, and no one cares which one, according to Consumer Reports, “really” tastes better. When S&P rated some tranche of a CDO AAA back in 2006, it meant that some poor analyst had run some model fed to her by an investment bank and made sure that the rows and columns added up correctly, and the default probability percentage at the end was below some threshold. It might have been crappy information, but it was new information. When S&P rates long-term Treasuries AA+, it means . . . nothing. And if any serious buy-side investor were tempted to take S&P’s rating into account, she would be deterred by the fact that the analysis that produced the rating included a $2 trillion arithmetic error.

When it comes to sovereign debt issued by major countries, investors already use their own judgment instead of following credit ratings. These are the current ten-year yields for fifteen countries that had AAA ratings on Friday:

  • Switzerland: 1.17
  • Singapore: 1.79
  • Germany: 2.34
  • Sweden: 2.34
  • United States: 2.56
  • Denmark: 2.58
  • Canada: 2.63
  • Norway: 2.63
  • United Kingdom: 2.68
  • Netherlands: 2.77
  • Finland: 2.90
  • Austria: 2.97
  • France: 3.14
  • New Zealand: 4.50
  • Australia: 4.64