Saturday, August 6, 2011

US Triple-A Rating And Popular Fiction

Previous postings addressed triple-A “as” fiction so why not one on “and” fiction

In “Default: Won’t Happen. Downgrade: Fear Not; Our Best Generals Are In the Field!” and “Default, Downgrade, Lions, And Tigers And Bears; Oh My!” the difficulties and risks associated with abandoning fictions were discussed. So far mass delusions haven’t been address. It’s time. So much fiction is associated with triple-A that it will be necessary to skip many fictions, perhaps to be addressed later. So, let’s dive into the important stuff. Hopefully, previous postings have made clear that the very idea of a risk-free return is a fiction, so it can be skipped.

Back in May of 2010 in a posting about bonds as an indicator entitled “Debt markets as an indicator or trade,” The Hedged Economist introduced the discussion with this summary of why bond markets weren’t an indicator; they were the cause: “Once debt markets realized how many people weren’t going to pay back their borrowing, debt markets froze. It started with mortgage debt, but spread via the shadow banking system. The cause of the spread was that liquidity was needed to adjust for the mis-priced Mortgage Backed Securities. The rush to liquidate (i.e., get liquid) rippled through every market in the shadow banking system. Any market and therefore any organization with a liquidity mismatch became vulnerable. That transformed a liquidity- driven contraction into a generalized fear about counterparty solvency. That was one of the unintended consequences of mark-to-market accounting as interpreted under Sarbanes Oxley.”

Well, the indicators of bond market stress have changed since then. They changed mainly because steps taken during the financial meltdown have suppressed the informational content of the behaviors in the markets discussed in that posting; they transfer the indications of stress to other markets. It would require a broad, complicated discussion to explain it in detail. But, basically, when central banks buy bonds across the maturity spectrum and flood the banking system with liquidity, the yield curve and interbank lending rates lose their information content.

One thing that is clear right now, regardless of whether the triple-A is lost, whether it was ever deserved, and what its loss will do. In mass, investors are adjusting to the reality that another group of borrowers aren’t “going to pay back their borrowing.” This time it’s sovereigns. Sovereigns have all sorts of ways to avoid paying back their debt. However, despite the showmanship in Washington, as the last three posting show, there should never have been an issue of outright default in the US.

By contrast, downgrade is a real risk and probably inevitable. We elected a president who says that if the public doesn’t cough up more money in taxes, we may default, and we have a Treasury Secretary who says that if we can’t borrow more, we’ll default. That just isn’t a triple-A financial management team. Either they don’t understand the real financial status of the government or they’re lousy financial managers. Even if what they said were true, that would indicate we’re hardly a triple-A credit. The fact that they represented it as true demonstrates that we’re not a reliable credit while they’re in office. But, as mentioned in “The US Will Lose It’s AAA Rating,” having a vocal fringe advocating a default only compounds the perception that we don’t take paying back our debts seriously enough to deserve triple-A.

What spreads the dislocation is the realization that the new risk means there are mis-priced assets, in this case Treasuries. That has a balance sheet impact on any organization holding Treasuries as prices adjust to the downgrade risk. Banks held $1.6 trillion in U.S. debt, agency securities, and government-backed mortgage bonds at the end of the first quarter according to Federal Reserve data. These firms also held over $80 billion in debt issued by states and local governments. State and local government ratings tend to be downgraded with the nation’s rating.

That has economic implications. When, and if, the new risk to Treasuries is priced in (“if” because the Fed could offset it), the banks will have to lend less to the private sector in order to rebuild their balance sheets. Further, banks face some obstacles to diversifying in order to reduce the risk. Why? For regulatory capital purposes, U.S. Treasury obligations normally receive a 0% risk weighting, while debt associated with agencies such as Fannie Mae and Freddie Mac are typically at 20%.

Pension funds and insurers have a similar exposure, but the focus on banks illustrates the link to the economy. Pension funds and insurers are also much bigger, so even if they hold more Treasuries, the Treasuries may represent a smaller portion of their portfolios. Banks hold more combined Treasuries and Treasury-backed bonds than either China or Japan. Sovereigns tend to only hold actual Treasuries. They all pale compared to the SS and Medicare funds. But, mark-to-market loses have little impact on SS and Medicare trust funds. They just ignore them. Similarly, the Fed, which also owns Treasury-backed debt, can just ignore the balance sheet impact.

As this was being written on Thursday August 4th, the markets were making exactly the move to increase liquidity as were described above in connection with the 2008 crisis. In some markets, it’s very orderly, while others were gapping (i.e., showing big price and volume changes between trades, called ticks). Commodities, including gold, stocks, bonds and currencies were all displaying the same underlying traders’ motivation.

However, the big difference this time is that no one was surprised by the sovereign debt issues. So, the move has been occurring over time. For example, complaints about corporations and banks holding cash have been on display for months. When borrowers aren’t a good credit risk and the sovereign debt is mis-managed, cash is a rational asset. Almost everyone who doesn’t understand that fact has chimed in, often without even checking their definition of cash. By threatening default the administration almost guaranteed a liquidity trap. They did it in a way that precludes their taking the steps one should take to address a liquidity trap, thus increasing the risk of a recession.

Friday showed another aspect of discarding fictions. As predicted in “Default: Won’t Happen. Downgrade: Fear Not; Our Best Generals Are In the Field!” volatility increased. The previous posting explained: “Because so much of the financial system as well as the public have been forced to make the adjustment rapidly, the risk of over shooting is very real. Consequently …volatile behaviors [previously] brushed aside are made more volatile” and “The ‘culture shock’ as people abandon one paradigm and adjust to another is another risk. It can freeze people in place or set off volatile behavior in totally unpredictable ways.” By the close, Friday didn’t disappoint in terms of volatility.

With that as background, let’s turn to popular myths. This one seems to be a fiction associated with the growth of media. It relates to the 24 hour news cycles, and also relates to the need to fill 24 hours. Basically, it involves fictitious segmenting of a single phenomenon.

To illustrate, let’s examine the stock market. There will be an explanation of the drop that purports to explain Thursday’s fall. It will differ either slightly or dramatically from what has been used the last few days, in fact all of July. The volatility on Friday will generate a different explanation. That’s the fiction created by the 24 hour news cycle. Similarly, there will be separate explanations for gold, oil, metals, stocks, bonds, and, if you dig, currencies. That’s needed to fill the 24 hours. The driver has been the same: adjusting to the risk associated with sovereign debt, specifically, in the US, the downgrade risk.

On some days a unique phenomenon may produce some quirky behavior in one of the markets (e.g., a crop failure or new harvest estimate, a margin squeeze, a default), but often one market’s performance is driven by another with a single factor driving both. But, by segmenting news, the fiction that what happened running up to August is now over is thus created. That ignores the obvious fact that when the President threatens default, people remember. It influences their behavior for a long time.

While one political party’s linking the debt ceiling to the budget was bad enough, the administration’s linking it to default will do more long-run damage than any single budget could do. The President’s and Geithner’s behavior was particularly irresponsible because they weren’t even negotiating with the principals on the debt issue. Ultimately, lenders, not Congress, will put an absolute ceiling on the debt. To illustrate, envision a future Congress raising the debt ceiling to infinity with no strings attached. Could the government then borrow an infinite amount? No. In fact, the real debt ceiling in the sense of what we could actually borrow would probably fall.

The notion that the debt ceiling deal “kicked the can down the road” is an increditable common fiction. As mentioned, the administration and Democrats approached the negotiations as if they were negotiating with a principal. In their posturing, they weakened their position with the principals by threatening a contrived default scenario. By threatening default they actually reduced the confidence of lenders which moved the threat of poorer borrowing terms forward in time. Further, as widely recognized, they made the AAA rating a bit of a joke internationally.

The genie is out of the bottle, and the new 24 hour news cycle won’t make it go away. To those of both parties who think paying national debt is an option or even that it can be discussed as if it was considered an option, the answer is simple. That’s not the behavior of a triple-A creditor. While the nation isn’t bankrupt, those philosophies are.

Now, let’s deal with the silly notion that the rating on the national debt is only a government issue. Seems to me we elected these people. If one didn’t vote, one allowed them to be elected. Our nation’s debt rating is a reflection on all of us. It’s funny that people will follow their credit score and think it’s important, but be cavalier about our collective credit rating as if they are an island standing apart.

At the other extreme, there are people who don’t care whether others expect them to try to pay their debts; they feel that paying their debts should be their unencumbered choice. Worse yet, there are people who think it’s unfair for people to expect to be paid back. They ignore the fact that it will have an impact on credit availability. Why? Because it is close to impossible to make someone lend money.

Now, a very important fiction: many people have a very self-centered view of what’s important. Since the triple-A rating has only an indirect link to their wellbeing, they assume indirect implies unimportant. The two aren’t equivalent. This has reduced the wellbeing of everyone.

One final fiction must be noted: some readers will think this posting reflects a political posture. The response to them is: please, remember this posting said nothing about any of the issues that the last posting ducked, like size of government (See: “Balanced Budget And Balance Budget Amendment: Dangerous Fiction”). It also never said whether the debt ceiling should have been linked to the budget, and it actually implied it shouldn’t have been linked. Finally, it never addressed whether the debt ceiling should have been raised or how much it should be raised. Even those who wish to see blame should have been disappointed. It’s about what happened and what it implies. Throughout this posting the focus was on financial management and economics.

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