US Downgrade is Inevitable

Would you lend money to a person or a company who was reported to have a AAA credit rating at AAA rates of interest if you knew that this borrower was two weeks away from defaulting on outstanding debt and specifically was relying on a decision to issue more debt to repay old debt?

In other words does the US sound like a credit worthy borrower? And does Capital Hill provide any additional comfort to investors that they are in control of the nations finances?

I am having a hard time understanding how the US has not been downgraded and I also don’t see how it should not be downgraded at this point even if the debt ceiling is raised. I don’t think any other borrower in this position would have maintained a AAA rating at the dawn of a technical default. If the rating agencies were really doing their job, they would at least cautiously have already downgraded the US to AA or lower.

Of course an easy and fairly true argument is that US Treasury bond holders are unlikely to stop being paid principal or interest. This might support a “bid” for Treasuries above and beyond an all out panic sale. However, if the company you owned bonds in stopped paying it’s employees, odds are you would want to reduce your exposure to that company.

The rating agencies have not been punished for their direct or indirect linkages to the credit crisis in 2008. Lehman Brothers after all was rated AA at the time of bankruptcy. However, if the United States were downgraded it would probably trigger an enormous wave of technical selling in the treasury market that could have unquantifiable and unprecedented knock on effect. Consider some implications, what might happen?

US treasury rates, for the first time in anyones memory would no longer serve as the proxy for risk free rates. What would this do to the ubiquity of risk free in financial models?

Discretionary money managers and fiduciaries holding treasuries for their AAA status would become forced sellers.

The long standing relationship between all credit instruments (bonds) and treasuries could break down. Most bonds trade at a “spread” to treasuries, as the proxy for the risk less rate of interest. These relationships could decouple.

Demand for other AAA currencies could sky rocket, effectively creating a bubble in other strong sovereign currencies, progressively raising the price of their exports and driving them into recession. Most of the worlds strongest economies have trade surpluses, a massive devaluation of the dollar could cripple these countries exports.

Demand for hard assets would likely go hyperbolic. Gold would likely explode in the ensuing weeks, and we would probably see spillover into all other freely traceable liquid commodities.

Borrowing rates for the US might rise in this scenario, adding to our existing debt burden.

Stocks would probably fall as credit markets could seize again creating issues for companies who rely on debt to finance operations.

Money market funds could break the buck.

Banks could fail as their safest collateral creates writedowns and impairments to their capital ratios.

Of course this list could go on, as it did in 2008. The difference here would be more than contagion, this could create a massive paradigm shift in the pricing of risk, the consequences of which are wildly unpredictable.

Of course most market participants could forecast a lot of this, and as game theory goes, they could choose not to panic, since not panicking creates the best outcome for everyone.

The 14 trillion dollar debt ceiling is really just the center ring in a three ring circus. Just because the spotlights are off of the outer rings of Social Security and Medicare, don’t be slight of handed into believing that the US will be ok if the limit is raised. We still have another 28 trillion or so that we don’t count in the current debt ceiling debate, pushing our debt to GDP ratio to well over 300% when you include these “off balance sheet” liabilities.

At the end of the day it seems to me our current AAA status is less an opinion of the United States balance sheet or economy but rather an opinion of the safety perceived by our Capitalistic Democracy. Only time will tell how this plays out. Let’s hope our leadership knows more about all this as they do about how to tweet pictures of their penis.

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