Watchdogs asleep? Some rating agencies not barking amidst debt ceiling standoff

Most major credit rating agencies are maintaining their top ratings on U.S. Treasury securities despite warnings that Congress’s failure to raise the federal debt ceiling could lead to default. Credit ratings are supposed to measure the probability of default — failure to pay promised principal and interest on-time and in full. But even after the debt ceiling expired on July 31 and Treasury Secretary Janet Yellen warned Congress that defaulting would “have absolutely catastrophic economic consequences,” rating agencies did not adjust their ratings.

With the House on recess until later this month, the debt ceiling issue seems unlikely to addressed until at least September. For the time being, the Treasury Department will be obliged to continue taking “extraordinary measures” to pay the government’s bills without issuing new public debt. The Congressional Budget Office expects these measures will work until sometime in October or November, at which time the federal government “would delay making payments for its activities, default on its debt obligations, or both.”

Congress has extended or suspended the debt ceiling several times over the last decade. Republicans raised the debt ceiling three times during the Trump administration, which added over $7 trillion in debt in four years. During the Obama administration, however, Republicans regularly opposed raising the debt ceiling, which contributed to Standard & Poor’s (S&P) citing “political brinksmanship” as part of the reason it lowered the nation’s credit rating in 2011.

Now, with Republicans once again wanting to portray themselves as being against accruing debt, Senate Republican Leader Mitch McConnell (R-Ky.) said Democrats “won’t get our help” in raising the debt ceiling.

Democrats could raise the debt ceiling without Republican support as part of their reconciliation package — if they can stay unified on the package. Many political observers were surprised the debt ceiling wasn’t included in the reconciliation bill’s original framework, which Senate Democrats passed.

Another method of raising the debt ceiling would be to include debt ceiling language in a continuing resolution. If passed by Sept. 30, a CR with a debt ceiling provision would avoid both a federal government shutdown and a debt default. But under current Senate rules, such a measure could be filibustered and would thus require Republican support.

While a debt ceiling default may be unlikely, it is not unimaginable. Most rating agencies have over 20 grades, most of which are different gradations of “unlikely” to account for various risks. A table published in a 2003 Moody’s methodology document associates its highest rating, Aaa, with a one-year default probability of 0.0001% — meaning a one-in-a-million chance of defaulting within one year. The next highest rating, Aa1, implies a default probability of six-in-a-million, and the third highest rating, Aa2, equates to a 14-in-a-million chance of default.

To me, a probability of six- or 14-in-a-million seems more appropriate for the current debt ceiling situation than one-in-a-million. Yet Moody’s, Fitch, DBRS and Kroll all continue to apply their top rating to U.S. Treasury securities, with only Standard and Poor’s applying a slightly lower AA+ rating among nationally recognized statistical rating organizations.

Aside from the current risk, a U.S. rating of Aaa/AAA seems incongruent with the country’s government’s fundamentals. Of the dozen countries carrying Moody’s Aaa rating, the U.S. has the highest net general government debt-to-GDP ratio, which, as reported by the International Monetary Fund, includes debt obligations from all levels of a nation’s government and deducts holdings of financial assets, such as gold.

For 2021, the IMF estimates that the US has a 109 percent net general government debt-to-GDP ratio, more than double that of Germany, at 52 percent, which is the second most indebted nation with an Aaa rating. The U.S. ratio is also much higher than Aa1-rated Austria’s estimated net general government debt-to-GDP ratio of 64 percent for 2021 and Finland’s ratio of 33 percent. Some countries with even lower Aa2 or Aa3 ratings — like South Korea and the United Kingdom — also have better net general government debt-to-GDP ratios than the United States.

Over the past year, Moody’s Analytics has repeatedly expressed support for Biden policies likely to expand the national debt. Before the election, in September 2020, Moody’s Analytics projected that real GDP would expand by 7.7 percent in 2022 if Democrats took control of Congress and implemented Biden’s campaign policies or by only 3.8 percent if Donald Trump and Republicans retained control. Then-Sen. Kamala Harris cited this Moody’s estimate in the vice-presidential debate.

In January 2021, Moody’s analysis of the American Rescue Plan Act projected the addition of 7.5 million jobs in 2021, a number that has been favorably quoted by President Biden on multiple occasions since.

Last month, a Moody’s report on the bipartisan infrastructure bill and reconciliation package estimated the infrastructure deal would only add $53 billion to the deficit over 10 years, far below CBO’s estimate of $256 billion — although the bill changed between the Moody’s and CBO analyses. Moody’s Analytics also concluded, “Worries that the plan will ignite undesirably high inflation and an overheating economy are overdone.”

Moody’s Analytics models use optimistic government spending multipliers that cast deficit spending in a favorable light, so producing reports bullish on Biden’s policies is not necessarily a sign of political bias. But given the pivotal role rating agencies play in the economy, it’s worth wondering what it would take for Moody’s and others to downgrade the U.S. credit rating.

For decades, Congress and presidential administrations have been piling up debt. Now there’s at least a small chance of a debt ceiling crisis that Treasury Secretary Janet Yellen warns “would cause irreparable harm to the U.S. economy and the livelihoods of all Americans.”

That warning, combined with the nation’s high debt burden, should cause rating agencies to objectively reevaluate the risks of a potential default in both the short- and long-term.

In the aftermath of the 2008 financial crisis and Great Recession, it was clear the rating agencies had failed to properly evaluate the risks of default in residential mortgage-backed securities and collateralized debt obligations. Now, it is fair to wonder if they are repeating those mistakes and failing to measure the federal government’s odds of defaulting.

Marc Joffe is a policy analyst at Reason Foundation, former senior director at Moody’s Analytics, and author of the study “Unfinished Business: Despite Dodd-Frank, Credit Rating Agencies Remain the Financial System’s Weakest Link.”