Doubling Down on a Triple-A Mistake: Britain Deserves its Top Debt Rating

The sounds of the final nails being driven into the crowded coffin of Chancellor George Osborne's austerity-led fiscal strategy are deafening and with each new chunk of disappointing economic data, the chorus of speculation that one of the so-called 'Big Three' of Moody's, Standard & Poor's and Fitch will lower its AAA rating on UK debt gains tenor and pace.

The logic, such as it is, links a rating on debt entirely denominated in domestic currency to the fortunes of the underlying economy and its perceived attractiveness to foreign investors.

It's a seductive argument and it will no doubt be validated in the very near future.

It's also a big mistake and will trap the ratings agencies once again into a spiral that ties ratings to perception rather than a ranked order of default probability (AAA being the lowest chance: CCC- being the highest).

Think back to the carnage of the credit crisis, when investors lost trillions on the plunging value of triple-A rated mortgage bonds and blamed the Big Three for being financial market rubes unable to distinguish between "risk-free" and "rotten-to-the-core".

The industry defended that accusation by correctly arguing that ratings opinions were never meant to serve as a guide for performance.

A triple-A rated mortgage bond might be impossible to sell in a falling market, but that doesn't make it any more likely to default. You handle the losses, we'll handle the analysis.

The recent fortunes of Maiden Lane III - the repository for AIG's "toxic" and "worthless" mortgage bonds set up by the US government - should have proven this conclusively.

Left to the whims of the market and the rigidity of fair value accounting rules, the billions in Maiden Lane III bonds would have sunk AIG and perhaps the entire US financial system forever.

Safely housed in the arm of the Federal Reserve, however, and shielded from "mark-to-market" valuations, the bonds recovered and were sold at a profit to the American taxpayer of $6.6bn in August of last year.

Knowing what we know now - that falling mortgage bond prices don't, in and of themselves impact the chances of people missing mortgage payments any more than you or I betting on the result of a football match influences which player may score the winning goal - the Maiden Lane recovery is entirely sensible.

Post hoc ergo propter hoc

During the hysteria that gripped the post-Lehman markets, it was harder to find an audience for it.

In effect, then, the ratings agencies were right and the almighty market - which had effectively outsourced its risk management duties rather than perform the hard-graft of fiduciary duty for themselves - was wrong.

Perception is reality, however, and the slur of being "behind the curve" in understanding the true value of the securities that ignited the first global crisis (mortgage bonds) has only served to embolden the Big Three to be ahead of the game in assessing the securities that sit at the heart of the second (sovereign debt).

There's no money in it - most sovereign ratings are assigned "pro bono" by the major agencies and are used as more of a public relations tool than anything else - but the reputational upside of being right does carry lucrative potential.

Investors, however, pay for corporate credit ratings because the men and women who crunch the numbers get preferential access to financial information and theoretically have the inside track in understanding a company's true risks.

A sovereign debt analyst at a ratings firm, on the other hand, is working on *exactly* the data as everyone else.

But if they're perceived to possess prescience on the fate of a government's financial future, the unspoken theory goes, they and their colleagues may also have similar foresight on corporate debt assessments that generate revenue.

And while that might be a compelling business model, it has little to do with Britain's economic fate.

Always Say 'Never'

Forget what you may have read about "Athens on the Thames" because the two nations - and their bond markets - have absolutely nothing in common.

Greece can - and nearly did - default because it needs to raise actual euros through either taxes or assets sales in order to meet interest payments and satisfy maturing bonds.

With currency sovereignty and an independent central bank, the UK simply, indisputably and unequivocally cannot - and will not - default on its debt obligations.

Ever. Under any circumstances. Regardless of what becomes of its moribund economy.

The proxy suggestion otherwise by any of the Big Three - through lowering the rank order of this probability compared to, say, Canada - is utterly absurd.

However, with the media once again hyperventilating with concerns over "sovereign debt bubbles" and "bond market vigilantes", accepting this fact seems positively heretical.

There should only be two - as opposed to the current ten - possible ratings for those countries with currency sovereignty and no foreign currency debt: AAA or default.

Now, this is not to suggest that money-printing to prevent default in a worst case scenario wouldn't have consequences. It would and they would be severe and would include cripplingly high bond yields, a plunging currency and hyperinflation to name but a few.

But each of these are market price manifestations and, seemingly, beyond the ratings agencies stated remit, which in the words of S&P's copywriters is the "ability and willingness to repay its obligations in accordance with the terms of those obligations."

The truth is that the impending downgrade - and it's coming just as certain as rain during Wimbledon - will be used by pretty much everyone *apart* from the investors the agencies prop port to represent.

Osborne's political rivals will use it to challenge his fiscal strategy, stimulus advocates around the world will use it to advance their policy agendas, media commentators will use it to support whatever grudge they have against bankers, politicians, economists, statisticians and fluffy kittens.

Bondholders, meanwhile, will do what they've been doing since they were burned by the ratings agencies the first time: ignore it.

Gilt yields have fallen relentlessly since the first hint of a downgrade by Moody's last February and similar counter-factual moves have driven markets in the United States and France following well-publicised falls from triple-A grace.

Doubling down on a mistake is never a good idea, but that seems to be what's driving the current zeitgeist in sovereign debt ratings.

Perception - political and financial - appears to be again trumping logic once again.