Economic Theory – Standard and Poor Credit Ratings – Speculative Grade Investments Do Happen, Folks – Austerity, On The Other Hand, Doesn’t Help – 27 April 2012

Here’s something interesting from Standard and Poor’s (you remember, the folks who brought you the debt ceiling crisis in the US last year?)

Turn to page 10 of this PDF to find out how Standard and Poor’s describes each of the ratings categories. Everything BBB- and above is considered “investment grade”.

Right now the Spanish are freaking out because they have been cut from A to BBB+:

Note that BBB+ is still “investment grade”.

Americans last year were freaking out because they were cut from AAA to AA+. AAA is the very top of the ratings, and AA+ is still head-and-shoulders within “investment grade”, and there are two categories of investment grade underneath that:

All that is interesting enough, but what’s really interesting is what they call the categories directly beneath BBB- … “speculative grade”.

That strikes me as a very odd thing to call an investment when you’re advising people not to make the investment. Speculation is, by definition, investment.

What the ratings companies are trying to say is that these categories underneath BBB- involve some risk, but not that investing in them is foolhardy. Indeed, the maximum default rate percentages for 1981-2008 for the B-level categories are low enough that it’s not hard to imagine investment houses with cash pouring out of their ears being willing to take the risk…BBB+, 1.11%; BBB, 1.40%; BBB-, 1.33%; BB+, 3.70%; BB, 3.06%; BB-, 7.04%; B+, 8.72%; B, 16.25%; B-, 32.43%.

Even for the lowest of these categories, over two-thirds of the investments will not lead to default. Those are, for venture capitalists with deep pockets, pretty good odds. Furthermore, if said venture capitalists with deep pockets invest in _countries_ where others do not because of the risk, and succeed, they will likely make more money precisely _because_ others choose to remain outside that market due to the risk.

This is why debt-fanatics are keen to excoriate Argentina for daring to renegotiate its debt and to selectively default to certain creditors, but skip past the fact that Argentina is now, a decade after its default, at a B rating sufficiently high to entice investment, with at least an 83% expectation of repayment of the investors.

The reason for the default in the first place was that Argentina didn’t accept that it had to pursue austerity policies that would savage demand in their economy in order to pay the debt back. Thus far, Spain _has_ accepted those policies, and yet, the country’s credit is still being downgraded.

Let me know if Spain’s credit rating drops below Argentina’s, or if Argentina’s rises above Spain’s. I plan to say “I told you so” a lot on that day. Take care of your economy, then you can pay your debts. Don’t take care of your economy, the debt problem is only going to get worse.

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