Sunday, 14 August 2011

4 Most Depressing Consequences of the Sovereign Debt Rating Downgrade

1) Washington plays the blame game

After the downgrade announcement by Standard & Poor's, politicians in Washington almost immediately put their PR activities in overdrive with what seemed like the sole motive of trying to pin the blame on someone.

The Republicans blamed Obama, the Democrats blamed the Republicans, everybody blamed S&P, and nobody really took the time out to accept that there was a real problem. S&P had even made it clear that one of the major reasons for the debt downgrade was that the irresponsible manner in which the debt ceiling debate was handled indicated that the political system was far from efficient in a time when the U.S. needs a strong political system.

Given that the U.S. Treasury came within a couple of days of defaulting on interest payments for its $14 Trillion debts outstanding, a situation brought upon by partisan bickering in Washington, and that a half baked bill was basically just handed in at the last minute to stave off a near term default without any solutions for reducing the budget deficit, and that even after a downgrade, the political system did not attempt to at least discuss options for reducing the deficit, but blamed the agency that cut its rating for making a mistake, it seems to us that S&P had plenty strong reason to at least state that the political system in the U.S. has become too unstable for a sustainable economy.

2) Otherwise Sane People Making Inane Comments

This has played out in a number of ways. There was the instance where President Obama stated that the U.S. "would always be a AAA nation." There was Warren Buffet, an otherwise very savvy investor and the largest shareholder of Moody's, the second biggest rating agency, claiming that the U.S. deserved a Quadruple A rating. You can find more examples by watching any 5 minute clip from CNBC's programming last week.

It is surprising that the same people who trust the rating agencies, who rely on the analysis performed by the ratings agencies, and in Buffet's case, who own the rating agencies, are basically trying to say that the recent downgrade does not apply.

The rating agencies exist to attempt to provide an estimation of the riskiness of investments. By attempting to write off the downgrade, what these otherwise sane people are doing is attempting to express their anger/frustration/etc. in a non-constructive manner.

It's pretty much equivalent to a bank denying you a loan by saying that you're not creditworthy and you storming out while screaming that one day you will buy the bank. It looks stupid and insane.

3) An Asset Bubble is Growing in Treasuries - Yes, the same thing that got downgraded

Speaking of stupid and insane, there seemed to be two assets that really jumped last week. One was Gold, and the other was Treasury bonds!

Alright, we understand that both Gold and Treasuries are taken to be safe haven assets. And yes, we understand that a downgrade of the U.S. Sovereign Debt rating is likely to cause global market turmoil (which it did).

But for crying out loud, who buys an asset at a higher price when it has just been announced that the asset had become more risky than before? And this practice of buying Treasuries was so widespread last week that the 10 year bond auctioned during the week sold at historic low yields (high prices).

Sure, the Federal Reserve announced that interest rates will be kept low until 2013, but the rates weren't changed. Sure, the yield curve may flatten a little bit, but only if there is not pricing in of the additional risk.

Unfortunately, it seems that the riskier nature of Treasuries is not being reflected in their prices and if this bubble is to pop, the consequences for the global economy may be close to catastrophic.

4) Currently used Financial Models can't handle a U.S. downgrade

Pretty much at the core of all the financial valuation models currently used is that underlying assumption that U.S. government debt is risk free. The risk of other assets are computed by adding the risk premium to the yields of risk free Treasuries.

Now if Treasuries are no longer risk free, these models cannot be used to accurately quantify the value of any financial asset. Sure, we could just use the Treasury yield as per market and allow the risk premium figure to be negative in case we are valuing a AAA rated asset.

However, there is no available data to compute negative risk premiums and no telling whether that model would work.

We are sure that the geniuses on Wall Street would come up with something to approximate the value of securities taking into account the added risk in Treasuries. When (s)he does, every bank, every pension fund, every insurance company, and many large companies and high net worth individuals would have to revalue their net worth. And there's no telling if there's going to be another AIG or Lehman as a result

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