FP Explainer

What Makes Credit Rating Agencies Issue a Downgrade?

It all depends on if the country is able to pay its debts, and whether it's willing to.

It's been a big week for credit rating agencies in global politics. On Wednesday, July 13, rating service Moody's (you might remember them from the subprime mortgage crisis) announced that U.S. bonds are ripe for a possible downgrade from AAA status as the political deadlock in Washington continues over raising the debt ceiling -- which regulates how much the U.S. government can borrow. On Tuesday, the agency downgraded Irish bonds to "junk" status. The country now joins Portugal, which was downgraded last week, and Greece as the European countries whose bonds are no longer considered investment grade. So what exactly determines these scores?

The ratings are a measure of how risky an investment a country's bonds are; they range from AAA (highest) to C (lowest). A country with a credit rating of BBB or higher is considered "investment grade;" below that is "junk."

To determine the rating, the agencies look at two main factors: One is economic (the country's ability to pay off its debts), and one is political (whether the government is willing to). The economic criteria include the country's revenue, fiscal and monetary policies, budgetary flexibility, level of inflation, public debt burden, and economic track record. On these criteria, the United States certainly merits its AAA rating; it's more or less taken as a given in global finance that U.S. government bonds are among the safest investments. On the other side of the spectrum there's Greece, where public debt is expected to reach 161 percent of GDP next year, its membership in the eurozone precludes simply printing more money to pay off loans, and a default is now considered a realistic possibility.

In the U.S. case, the threat of downgrade is due to political, not economic, reasons. Washington could easily continue borrowing money in order to pay off bondholders. But unless Congress and the White House can reach a deal to raise the $14.3 trillion debt ceiling by Aug. 2, the United States will be legally unable to do so. The latest announcement from Moody's essentially amounts to a warning to Capitol Hill and the White House that the global financial community isn't amused by the partisan bickering. 

A downgrade from AAA to AA is not, in itself, a catastrophe. Japan's credit rating has been steadily downgraded for years -- not exactly a vote of confidence, but even at AA-, the risk of a Japanese government default is pretty minor.

A downgrade from investment-grade to junk status is much more serious. Most major fiduciary firms, such as pension planners and insurers, are forbidden from investing in junk bonds. That means that countries like Ireland, Portugal, and Greece now have a much smaller group of investors who can buy their bonds. Those that can and do, of course, will demand a much higher rate of interest to account for the increased risk of their investment.

An actual default -- even a brief "technical" one -- of the U.S. economy could be cataclysmic, as it would lower the country's credit rating, resulting in higher interest rates and raising the Treasury's borrowing costs by billions. Think of it as the consequence of not paying your mortgage or credit card bills. An extended failure to repay bondholders could lower the rating to a point at which mutual funds will be required to divest, forcing a sell-off of trillions of dollars in bonds.

It wouldn't be pretty.

Thanks to Peter Marber, chief business strategist for emerging markets at HSBC Global Asset Management.


FP Explainer

Why Would Someone Hack the IMF?

To see how the sausage is made.

In addition to finding a new managing director and awaiting the prosecution of its most recent one, the IMF now has a serious cybersecurity breach to deal with. The New York Times reported over the weekend that the organization had been hit by "a large and sophisticated cyberattack whose dimensions are still unknown." The fund declined to provide details to the Times about the nature of the breach, but it was apparently serious enough that the World Bank immediately severed its computer links to the IMF. But besides Dominique Strauss-Kahn's emails, what's worth stealing from the IMF?

Not as much as there used to be, but still potentially a lot. The IMF now makes a lot of information public that used to be kept secret, such as the terms of loan arrangements with recipient countries. But as with the State Department cables released by WikiLeaks last year, the juicy material may not be so much what policies the IMF is following toward given countries as how it's talking about them in private.

The minutes of IMF executive board meetings are not made public until several years after they take place. Meetings of the board presumably include candid discussions about the financial solvency of countries requesting bailouts. In both meeting minutes and informal remarks over email, officials often discuss countries' internal politics and economic policies in terms they would never use in public documents. It's not exactly unheard of for countries to misrepresent their economic data. If IMF officials were shown to be privately questioning member countries' official figures, it would certainly have the power to move markets.

Like any multilateral organization, IMF members also seek to push their own interests, and it's certainly possible that major shareholders like the United States and Britain may advocate for more favorable loan terms for allies. Again, this isn't exactly secret, but it isn't the sort of thing governments want to see dissected in the media.

Of course, not all cyberattacks are aimed at stealing information or orchestrating WikiLeaks-style data dumps. Sometimes, they're just done to prove a point -- as in the recent attacks by the mysterious group LulzSec on Sony, Fox News, PBS, and others. In fact, just two weeks ago, the IMF received a threat from the "hacktivist" collective Anonymous in retaliation for the fund's activities in Greece. "The overreaching powers of the European Union (EU) and the IMF will not go unnoticed or unopposed by the global community who stand in solidarity with their brothers and sisters of Greece," read a statement attributed to the group.

Despite the threat, there's no indication that the recent attack was carried out by Anonymous. One hacker advising the U.S. Department of Homeland Security told Reuters that the intruder was likely working on behalf of a nation-state looking to steal sensitive information for economic advantage or to simply embarrass the organization.

With an organization as controversial as the IMF, the list of suspects is long. On the other hand, it's not as if a country could exactly issue a news release containing secret IMF data (though it could potentially invest in a country about to receive a loan). This may turn out to be a case in which using the information may prove just as difficult as stealing it.

Thanks to James Vreeland, associate professor of foreign service and government at Georgetown University.