What does the Bond Rating Really indicate?

The rating of a Bond is only a rating agents measure (OPINION) of the issuer of that particular obligation likelihood to meet the terms and conditions of the obligation, i.e. make the right coupon payments on time and return the promised principal on time.  The rating says absolutely nothing else about other risks, much less what those risks might be.

And you remember the saying that “Opinion are like assholes, everyone has one”.  That especially applies to this article.

The rating of debt obligations was originally only applied to commercial debt not sovereign debt.  The application of rating to dedicated revenue backed governmental debt (Municipal Bond) may be appropriate.  The application of this type of rating to sovereign debt may be totally inappropriate.

The issuing agent pays for the rating (So who interest does the rating agent really represent?), which should be your first clue.  It was offered as service to the potential buyer (how to dress your pig), your second clue.  And off course it was offered as being unbiased (The rating agent get their money up front), your third clue.  Finally the rating agent does not participate in the debt market (The rating agent has no skin in the game), your forth and final clue.

Sovereign debt has some additional issues that currently is not or cannot be addressed by the rating agents.  The greatest and most pernicious is the risk associated with the likelihood of the issuing sovereigns to inflate their currency.  The commercial issuers bonds typically do not have any direct means to inflate their currency, unless they are state owned industries (AKA People Republic of China).

In many cases commercial issuers of debt typically are forced to issued assets back debt, where as sovereign debt is not back by any real assets, other than the words that the issuer of debt backs the debt with the following words “Full Faith and Credit of the “Fill in the Country Name”.  In other words sovereign debt should be viewed with some suspicion and possibly viewed as being subordinated debt.  If the country defaults, you as the bondholder have claim, a very tenuous claim.  If you hold the defaulted paper long enough, you might get a pittance back at some distance point in the future, but you are just a likely to get nothing.

If a commercial issuers of debt issues subordinated debt, there are currently 4 recognized levels of subordinated debt in the FpML (Sub Tier1, SubUpperTier2, SubLowerTier2, and SubTier3), it in some cases it could carry the same rating as senior debt issued by this entity, since the rating supposed to be only a measure of the issuer ability to meet the terms an conditions of the note.

If the company has issued already issued large amounts of senior and subordinated debt well in excess of the value of the company, the rating agency may determine that it is more likely or not that the issuer of the debt will not be able to meet the terms and conditions of this instrument, and hence provide a lower rating.

Typically subordinated debt already come with higher stated interest rate, this is done to entice potential buyers to overlook the possibility that the borrower may not be able to meet the terms and conditions of the instrument.  If the issuing agent does not like the rating that a particular rating agent assigns to an instrument, there is nothing that precludes the issuing agent from NOT passing this information on to any potential buyers (Since they are dressing a Pig), and seeking another review that is possibly more favorable (They like a Pig in a red dresses).  And as stated earlier, the rating is only an Opinion, and it is based on information provided to the rating agent by the issuing agent.  If the information is questionable or fraudulent, any recourse is not against the rating agent but against the issuing agent.

The Bond rating was was never designed to measure risk or safety of an instrument.  It’s uses as a measure of safety of one obligation versus other investments is a perverted misapplication of the rating and as such the buyer should beware.  It is not the first perverted misapplication of a measure in the world, nor will it be the last.

You can have two instruments issued by sovereigns both with Triple “A” rating, but the first issuing agent has a long and glorious history of currency manipulation.  The second issuing agent is not known for this type of behavior except in the most dire of circumstances.  Both instruments are issued with the same stated interest rate, but will the bonds have the same effective interest rate?  The short answer is an emphatic NO.

Both issuers of the debt have a long history of meeting the terms and conditions of the instruments, hence their instruments should carry the same Rating.

The issuer of the debt with the long and glorious history of currency manipulation will pay a higher effective rate, since knowledgeable purchasers of his debt will only offer an appropriately discounted bid for this debt.  This reduced purchase price should produce a yield that should account for the risk for the anticipated currency inflation that the issuing agent is likely to create in attempt to reduce the cost of this debt.

In the end there are two instruments with the same rating, but with different effective interest rates.  It is this effective interest rate that connotes a more accurate valuation of the risk associated with an instrument, not the rating.

It appears that sovereign debt regardless of it’s rating carries far more hidden risk than other forms of debt, particularly secured debt.  The thought that Treasury notes were or are riskless is a very quaint idea, you know like the Easter Bunny, but in fact it is nothing more than an illusion since they can inflate the currency; after all it was or is just a spot to put your money when you did or do not know what to do with it, another misapplication of a measure.

Using your own countries Sovereign Debt regardless of the instruments rating as core assets for the banks in your country can be done, and has been done, it creates a ready market for your countries debt.  You only owe your self; you have conjured wealth out of thin air.  Since the obligation is denominated in your currency, and if your government chooses to inflate their currency the market price floats, everything appears to be fine, you do not see the inflation.

Using Sovereign Debt of another country denominated in your currency as core assets for your banks is folly.  The debt that you hold may not “Change” in value in the normal course of actions, with the exception of if and when via force majeure that Sovereign defaults on the debt.  The have conjured wealth out of thin air, and you have no effective mechanism to keep them from conjuring more wealth.  On the surface your banks appear to be capitalized, but your banks in reality are under capitalized.  You have exposed your capital markets to outside forces, which you have very little if any control of.  (Can You Say EURO?)

Using Sovereign Debt of another country denominated in that countries currency as a core assets for banks in your country is sheer lunacy.  They have conjured wealth out of thin air, and for you the wealth should appear to be more of an illusion then a reality.  The value of the debt rises and falls with via the interplay of the two currencies, for which both governmental policies have direct effects.  The banks capitalization is constant shifting, one moment you are ok, the next moment you are not.  You can band aid some of the effect by reducing leverage applied to these assets.  If that were the case you would be better off using your own Sovereign Debt, more bang for your buck.

As Always “Caveat Emptor”, or for those who do not get Latin, “Check Your Six”.  Which are really nice ways of say that you should only risk funds that you can afford to lose.

Another Shot to Groin

So how hard would it have been to have a real program to provide a real Hepatitis B vaccination project in Pakistan instead of a fake one?  I am sure that it was more a question of cost rather than intent.

And we wonder why the people of the world, especially in the middle and near east do not like us or trust us.  It is crap like this that will cause our downfall.  It is behavior like this that will push more individual into the fight against us.  It is another sign that our opponents can point to as a reaffirmation of our behavior and intent towards them.  The best part for them is that they did not have to invent it we did it for them.  It is not a story cobbled together from a bunch of half-truths and innuendo, it is the real deal, and we cannot deny it.

But we got our man, but at what cost?  It appears that little if any thought was given about our future relationship with these people and their government. It should not be totally unexpected that the government of any of these countries where United States sponsored medical program are operating to questions these programs, with particular emphasis on the programs organization, operations, and oversight.

We should be ashamed of our selves, but from what I can read we have not shown any remorse, or outrage.  Do not get me wrong, Osama Bin Laden was a criminal, and needed to be dealt with for his crimes.  But the program to provide vaccinations could have with a little more effort have been the real deal, and that is were the story would have ended.

It’s going to suck to be an American

The United States of American (WE) needs to reduce our spending.  WE have two basic paths available to us to perform this task.  The first is that WE voluntarily reduce our spending (WE at least have some control).  The second is that rest of the world mandates our spending reduction, they either do not buy our debt at the offered rate, or force us to accept it loan shark rates (WE have no control).  Can you say Greece!

The first path has two forks that we could take.  The first fork is a Crash Dive/Jump off the Cliff  (Tea Party anyone?).  A jump off the cliff excess spending, and let the chips fall where they may, with all of the chaos and economic shocks that ensues.  The second fork is a controlled decent.  The reduction of spending in a controlled and orderly manner in order to reduce the shock it is going to apply to the economy.

The Crash Dive/Jump off the Cliff path does not appear to be very reasonable in that WE do not know the extent of damage that will occur in our country and economy.  It is hoping that we do not exceed structural limits when we try to return level flight, in attempt to keep from hitting the ground.  This method can be quick it can also leave long lasting scars on the country and the economy.

The control decent is a more reasoned approach.  It will allow for some mitigation of damage that will occur in our country and economy.  This path is longer than the Crash Dive path.  This path is not a large and possibly fatal shock to the system, but please do not under estimate the fact that it will still be a significant shock, and some of it’s effect will be very unpleasant, and not limited to a few select individuals.  WE all gained from the situation getting here, WE all should stand some of the loss getting down.

WE are a debt addicts.  Like all addicts, when the addictive substance (Debt) is removed, the withdrawals are not pleasant.  WE will have to endure the withdrawals and hopefully come out on the other side with a better understanding of who, what and where WE are.  There is no guarantee that WE will come out on the other side.

Regardless of which path we choose or is chosen for us by others, things will not be the same in America.  Many individual will suffer.  Many will suffer because of decisions that they made.  Remember that a decision not to make a decision is a decision.  If I had to guess the very young and old will suffer more than any element of our society.

Some industries will disappear never to return, some will be mere shadows of their former selves.  Some existing industries will rise to new prominence.  New industries will emerge.  It will be very unsettling times as the power structure is recreated.

This will be a time when the economy will not grow it will even shrink.  Unemployment will increase.  Initially government revenue will shrink, as the economy shrinks.  We will have limited means to provide anything in the way of relief to our own.  WE have already expended most if not all of that ammunition.

WE cannot and should not expect help from others, the world is not a kind and gentle place.

Do WE have the will to take control of our nations path; at the present time I would say NO.  The friggin ship is sinking and the bridge crew is arguing about where to place the tables and chairs.

I have always held a belief that all systems are self-correcting.  I have also held the belief that you do not want to be around when a system self corrects, because the old rules do not apply, and you do not know what the new rules are.

WE (The United States Government) have been spending like there is no tomorrow, and if we keep spending like we are there will be no tomorrow.  The graph below show just how bad it has gotten lately.

I am not calling for isolation of the United States, but we need to be far more prudent on when and where we spend our money and forces overseas.  The cost associated with supporting various cold war institutions must be reviewed with an eye to their effectiveness in supporting the national goals of the United States.  Everyone says that they need help, and that may be true, but we only have a limited amount of treasure and bloody that we should be willing to spend, so we must choose wisely.

Some of spending reductions are going to be no brainers.  Most of these no brainers will affect people outside of the United States.  WE have declared victory in Afghanistan, and the game of musical chairs between us and the other NATO allies has started in Afghanistan.  The Iraq Government has informed us by their silence that we are expected to leave by the end of the year.  All of these events should cause the examination of our current armed forces structure, and missions.  Some of these no brainers will affect people inside of the United States.  The reduction of forces in the Middle East, and the possible reduction of operational tempo of our existing forces will affect foreign companies, or the foreign subsidiaries of American companies.  The possible of reducing the size and shape of our standing armed forces, will directly affect the American people by increasing the number of unemployed.  The possible reduction or cancellation of various weapon system, will have a direct affect on both the top and bottom line of American companies, and indirectly affect Americans who own their stocks and bonds. It will affect the American people again by increasing the number of unemployed.

The spending reductions are going to be tough to come up with and tough to maintain because it for the most part will only affect millions of Americans.  In many cases it will reduce the standard of living for many, as direct government payments and subsidies are withdrawn.  Additionally a significant portion of our economy will see a reduction in demand for goods and services as government spending is reduced.  The knock on effect is that many of these organizations will be disproportionately hurt as find that they too much production capability for the given demand, and they to will have to make adjustments, that also will add to number of unemployed.  Remember that these organizations also disproportionately gained on the way up, their main problem may be that they became too dependent on one customer, which one could argue is a gross failure of their management.

Finally there will be the changes to the rules that WE have been operating under for all these past years.  It will take time for the economy to adapt to these new rules.

Some will argue that a particular no brainer spending reduction is so small that it does not significantly contribute the overall cause.  My rebuttal is that for every small spending reduction on a no brainer results in a possible easing of a tough spending reduction.  So let us take care of the small one first, to get a better handle on the tough ones to follow.  The tough spending reductions will be hard.

The spending reductions will particularly affect those who did not save for a rainy day.  Spending reduction will particular affect those who have significant amounts of unsecured debt and no sources of income.  In all probability the negative effects will disproportionally affect the very young and very old.  Many will say that it is unfair, to punish these individuals, and they maybe correct.  But everyone has the choice of being either a Grasshopper or an Ant.  I was always told that life is not fair, nor just, and that everyone pays for their decisions, one way or another.  I was also raised to expect the best, but plan for the worse.

But to those that say that the situation is unfair, remember that many of these individual choose to life for today, and not think about tomorrow.

There is one group regardless of which path is taken that it will be extremely hard on, that group is our elected representatives.  Some will argue that it is not there fault; they did not start this cycle.  My answer is crap, you did not stop it, nor in many cases you did not attempt to slow it, or stop it, or show your displeasure of the situation via you vote.  From my vantage point you were there for today, and not tomorrow.

The one path that WE must avoid is to have the world dictate the terms and conditions to us either via the value of our currency, the interest rates we pay, or a combination of the two.  WE have had a fairly easy time of it given that our currency is currently the worlds reserve currency, the moment that condition fails, the situation will be much worse for us.

Whatever path is taken:  “It Will Suck to be an American” for the next few years, because there will be no deus ex machina.

Take it to the Limit

This on going circus we call the United States of America is starting to sound like the refrain from an Eagles song.

“So put me on a highway
And show me a sign
And take it to the limit one more time”

As much as all of the crap that is taking place in Washington is turning my stomach, it is unfortunately obvious to even the most casual observer that the government will have to increase our debt limit.  But to the same observer it is also obvious that we (The People) cannot continue down this path of allowing the government to spend more than the government collects.

The following is a plot of Revenue and Expenditures per Person for the United States since 1980.  The curves are divergent.  The Great Recession of 2008 certainly did not help the situation all it really did was to accelerate the divergence between the two curves.

Real spending cuts must take place.  Real revenue increases must take place.  We the people have allowed our government collectively since 1981 to expend on average $1.20 for every $1.00 of revenue.  Some years have been much worse.

Source http://www.fms.treas.gov/mts/index.html

After the limit is extended, and the United States Debt offering is downgraded by the various rating agencies and the bond market starts to into the punishment phase of the market reaction.  This already appears to be baked into the mix.

How much of a haircut do we get to take?  It looks like 50 percent just to get to even, see the graph above.  So through some very arcane and macabre process we call the United States Congress, spending needs to be reduced, and revenue needs to be increased.  Is the gap closed by 50/50 split between expenditures reduction and revenue increases?  Is it a 75/25 split, or is a 25/75 split?  I have no bloody idea.  50/50 at first blush appears to be the fairest.

There are three things that we do know.  1. We will not close this gap via spending reductions alone.  2. We will not close this gap via revenue increases.  3. We will not be able to continue to fund this gap via the issuance of sovereign debt.

So Take it to the limit one more time, it might be our last.

Is it time to call for a Constitutional Convention?

Do we need to call for a Constitutional Convention for proposing Amendments per the requirements of Article V of the United States Constitution?  Can we get 2/3 of the state legislatures to introduce and pass binding resolution, by veto proof majorities?  Can we get 3/4 of the state legislatures to introduce and pass the proposed amendment by veto proof majorities?

To carry on with the tongue and cheek comment by Warren Buffet concerning how to solve the deficit mess. Instead of hanging the Sword of Damocles over the heads of the citizens about the current deficit situation, and threating to blow all us of out of the water.  Why not put the Sword over the heads or our elected legislative members.  Putting their jobs on the line if and when they as a body cannot do the job.

Do we the people want or need mechanism to help up make the hard choices?  Forbid that "We the people"  actual take some initiative and responsibility for this current mess.  If the answer is that we require such a mechanism to save us from our selves.  The following might be such a mechanism.

A proposed amendment to the United State Constitution could read something like this:

Here by let it be resolved and agreed that all sitting members of the Congress of United States, either duly elected or duly appointed would not be eligible to stand for re-election to for any seat in any of the legislative bodies as defined in the United States Constitution in the subsequent congressional election cycle if the United States Treasury annual computed Current Accounts has a deficit greater than 3 percent of the United States Department of Commerce computed Current Annual Gross Domestic Product during the current congressional term they are serving.  Additionally setting members of the current United States Congress in which the Current Accounts exceed the Current Annual Gross Domestic Product shall be ineligible to be appointed to any open seat in either of the legislative bodies for the current term of those bodies, and the subsequent natural term of those bodies.  The terms of this amendment may be suspended for the remainder of the current Congressional session by two-thirds supermajority vote in both houses of the Congress of the United States of that Congressional session.

So why do we need something like this?  Let us look at some statistics concern the current United States Congress and the two previous incarnations of that body.

In the 109^th Congress the average age of the members was 56.0 years.  The average age of a Representative was 55 years.  The average age of a Senator was 60.0 years.  The dominant professions of the members are Law, Public Service/Politics, and Business.  The Average length of service for a Representative was 4.3 terms, or 9.3 years.  The average length of service for a Senator was 2.01 terms or 12.1 years.

In the 110^th Congress the average age of the members was 57.0 years.  The average age of a Representative was 55.9 years.  The average age of a Senator was 61.7 years.  The dominant professions of the members are Public Service/Politics, Business, and Law.  The Average length of service for a Representative was 5.1 terms, 10.2 years.  The average length of service for a Senator was 2.1 terms or 12.8 years.

In the 111^th Congress the average age of the members was 58.2 years.  The average age of a Representative was 57.2 years.  The average age of a Senator was 63.1 years.  The dominant professions of the members are Public Service/Politics, Business, and Law.  The Average length of service for a Representative was 5.15 terms, 10.3 years.  The average length of service for a Senator was 2.2 terms or 13.4 years.

All of the above data is from the Congress Research Service, Library of Congress reports for 109^th, 110^th, and 111^th Membership Profile reports.

I hear about all of the new/young blood coming into the Congress from the various news services and yet the data indicates that it is a bunch of crud.  The average Representatives average length of service since the 109^th Congress has increased by 19.7 percent.  The average Senator length of service since the 109^th Congress has increase by 10.8 percent.  The house members have had to stand for two election cycles since the 109^th Congress.  That was two chances to change the makeup of United States House of Representatives.  A third of the Senate has had a chance to stand for one election cycle.  For one group it was two chances, for the second group it was one chance to put the fear of God into someone.

So as one can see “We the People” have been throwing the bums out (NOT).  Yes we the citizen of this republic have been doing our job (NOT).  Meanwhile the leadership of this country and the citizens are just pissing time away, and digging the pit deeper.

I am not sure that our founding fathers really wanted the country that they founded run by individuals who identify their occupation as Public Service/Politics.  The signers of the Declaration of Independence were Lawyers (25), Merchants (15), Farmer/Plantation Owners (9), Physicians (4), Scientist (1), and Minister (1).  As best as I can tell none of them really identified their occupation as “Public Service/Politics”.  Many if not all of them practice Public Service and Politics, but they were not so bold as to declare it as an occupation, with all of the attendant baggage that an occupation has.

Why the hell are the Tea Party members not pushing an agenda like this?  Here is their chance to make a lasting mark in the history of the United States, as opposed to being an over looked footnote.

Status of Forces Agreement (SOFA) Iraq

Earlier this year senior members of the Department of Defense, Department of State informed the government of Iraq, that after the June/July time frame it would be impossible to stop the withdrawal of United States Forces from Iraq, and that if the government of Iraq wanted these forces to stay in place the government of Iraq need to officially inform the United States government of that fact.

To date the Iraq Government silence on the subject has spoken volumes.

The answer has been polite silence, which mean NO we (Iraq) feel that we (Iraq) do not require the presence of your (United States) forces in our (Iraq) country.

Thank you for all that you have done.  Words fail us at this time in describing what you have done.  Peace be with you, but by all means please depart as you said that you would in the SOFA.

Now it is time for United States to prove to Iraq, and to the world that we honor our agreements.

The United States Armed Forces in Iraq should start drawing down forces.  I would recommend that we accelerate the withdrawal such that all of the deployed forces are home for the winter holidays (Thanksgiving through New Year).

Will the withdrawal of United States Forces have dire consequences for Iraq?  Yes, most likely, but not immediately.

Will there be a civil war in Iraq?  Yes, and as we have already seen it will be along existing religious and ethnic divisions.  We just stopped it.  We did not solve the situation we just delayed it.

Will there be situations where the United States Forces should go back in to Iraq?  Maybe.

Will United States Forces go back into Iraq?  Yes, but only under the most dire and desperate world threating situations, and in all likelihood as a member of a coalition.  Given our recent history, when the American people do allow a return to Iraq, it maybe almost too late, since several of the previous administrations may have cried wolf once to often.