Saturday, August 6, 2011

Officially Downgraded: What Happens Now?

For those of you who haven’t already heard, Standard & Poor’s recently downgraded the US credit rating from AAA, which it had always held, to AA+.

This came after a long meeting last night held between the Treasury department and S&P where they tried to convince them not to downgrade the US. As we all know, they were unsuccessful.

I have to say that I’m a little bit surprised by these news. Credit rating institutes are not famous for being harsch; as a matter of fact, they’ve gained a reputation for being spineless and easily manipulated by financial institutions. Case in point, they gave their precious AAA rating to thousands of CDO’s and CDS containing worthless subprime mortgages. Banks like Goldman Sachs managed to convince them that subprime mortgages were a perfectly safe investment, but the Treasury could not convince them that US bonds are. The other rating agencies who threatened to downgrade the US chickened out in the last minute, so I was myself fairly convinced S&P would do the same. Congratulations on telling the truth, S&P!

Many analysts, in particular on the left, argue that because the rating agencies made so many mistakes during the last boom, no-one really trust them anymore. That’s simply not true. Yes, many of those who are professional government bond traders make their own evaluations and so the S&P rating doesn’t affect them very much. Still, for the following reasons, the downgrading is bad news:

1) Everyone takes a closer look. People and investors (among them mutual funds) who have always held American bonds, assuming them to be absolutely risk-free, will now take a closer look. These people have never analysed American bonds, never run them through any valuation model or anything, they’ve just bought them because… well, they’re risk-free, or so they’ve always heard, and everyone else bought them, and why take a shot with a foreign bond? You can’t really trust those canadians, can you? This downgrading sends shockwaves through the financial system and makes everyone take a closer look on the American economy. They may very well find that the situation is even worst than what S&P thinks. In a worst case scenario, this could lead to a massive flight from American bonds.

2) Interest rates go up – and so does unemployment. This downgrade is estimated to cost the government about 100 billions. But the effect doesn’t end there. When interest rates on bonds go up, so does interest rates on everything else. Your mortgage becomes more expensive. That loan you took to buy your car becomes more expensive. If you’re a small business owner and you want to borrow money to expand your business, you’ll find yourself paying even more than you would have done last month. Naturally, this all leads to a drop in investment and higher unemployment. Remember that unemployment is largely based on expectations: Employers hire and fire based on how they expect the future to be. A company that is having a hard time, but which expects the future to be good, will do everything to hang on to its employees and may borrow money to pay salaries rather than laying off staff. A company that is currently in the black, but which expects tough times to follow, may start to lay off staff (because of regulations, firing someone can be a complicated process that you better start with as early as possible), negotiate pay cuts and overall warn employees that layoffs may come in the near future – which will of course make them tighten their belts and overall lower their confidence in the economy. Remember that just because borrowing costs increase by 100 billion dollars a year, that doesn’t mean spending will be cut by 100 billion dollars a year. Instead, the US will most likely borrow 100 billion more every year, which means 100 billion dollars less that could have been used by entrepreneurs and businesses. Needless to say, this is not good for the economy, which already appears to be entering a new recession.

3) The floodgates are open. Once you’ve lost your credit rating, it is very easy to lose it again. In early 2009, Ireland still held a perfect AAA rating from S&P. Now, it’s BBB+. The S&P has already warned that the US might lose its rating again within 12-18 months, down from AA+ to AA, unless you can convince them that you are serious about cutting the deficit. Is it likely that congress will pass even more cuts than they already have? They would have to tear up the current agreement, signed just a couple of days ago. 4 trillion dollars in cuts, that’s what the S&P demanded. Will congress agree to another 1.5 trillion? Will they even go through with the 2.5 that they’ve promised? I’m sceptical. And now that the S&P has led the way and downgraded the US, it probably won’t take long for their colleauges in Fitch and Moody’s to grow a pair and do the same. It is also very hard to regain an AAA rating once you’ve lost it. Do not assume that if only you elect a Republican president, you’ll get it back in a second. You’ll have to fight hard for it, mark my words.

4) The Chinese dollar reserve. China is an eternal boogeyman for conservatives who have hated them since the Korea war. While I’ve always emphasized that China does not pose the kind of threat conservatives think they do, it is a fact that they have a huge dollar reserve and that if they were to sell it, they would destroy the value of the dollar for the foreseeable future. Worst, every other country which has a dollar reserve (no, China is not alone) would do the same. Many conservatives think that China would sell their dollars just to mess with the US, but I don’t think so. However, if China believes that the US is on an unsustainable fiscal path, they just might do it. If they believe the American government is about to destroy the value of the dollar without their help, they’ll want to get out while their dollars are still worth something. Just like if you think a company is about to go bankrupt, you’ll sell your shares while they’re still worth something. The Chinese, by selling their dollar reserve, might just fasten the US demise. But they won’t cause it. You caused it.

Now, let me counter some arguments from those who claim that the downgrade doesn’t matter or that the administration is not to blame.

1) No-one trusts the agencies. Like I mentioned earlier, there are those who claim that the rating agencies are so discredited that this won’t matter. The rating agencies are all still around and their services are still used, so obviously they are not entirely discredited. Plus, the real reason why they gave out AAA ratings to subprime mortgages during the last boom was because they were essentially bribed by financial institutions. It’s not like they didn’t understand the subprime mortgages were worthless, they just didn’t have the character necessary to speak up about it. That reflects badly on them, of course. Still, they do no doubt know how to measure credit risk. They may lack character, but they don’t lack the skills. Therefore, you may have reason to be suspicious when they give a country or a company an AAA rating (since you don’t know if they are doing it because the rating is deserved, or because they’ve been bribed). Yet, when they downgrade a country, you got good reason to trust them. Unless you think someone bribed them to downgrade the US, and if you do, thanks for stopping by Mr President.

2) The S&P made a miscalculation. No-one has specified to me exactly what exactly this miscalculation was. I’m guessing the S&P simply saw through the political rhetoric of Obama and realized that his estimates (whether they were estimates for revenue or spending) were 2 trillion dollars wrong. And personally, I trust the S&P more than I trust this administration. Also, whether the S&P are right or not, investors do trust them. It doesn’t really matter in the short run whether they are right; it’s all ’bout the expectations. If people think the S&P are right and that you are not a completely safe investment, they’ll act as if you’re not. And then you won’t be.

3) 100 billion dollars is not that much. It’s just a matter of time before leftist bloggers and pundits start to compare the increased cost of borrowing to the cost of the Iraq war or the Bush tax cuts. So, as a pre-emptive strike against those comparisons, let’s just first say that two wrongs doesn’t make one right. Whatever you think about the Iraq war or the Bush tax cuts, 100 billion dollars is a whole lot of money and this additional cost could have been avoided by common sense fiscal policies.

4) It’s Bush’s fault. Count on this to be Obama’s mantra during the election campaign. They will point out that government debt grew under Bush’s watch, and that had Bush only balanced the budget, those 4-5 trillions Obama has added to the deficit wouldn’t have mattered. While I wish Bush had balanced the budget, Obama is now the President and the buck stops with him. Obama borrowed money to stimulate the economy, and if the stimulus package had worked, the US would have gotten that money back by now. The unemployment rate would be 5 % rather than 9 % and growth would be high as well as stable. That’s what was supposed to happen, that’s what we were promised, but that’s not how it turned out. When unemployment goes down, tax revenue goes up, so if the stimulus had only managed to bring down unemployment, then at least some of that money would have come back. Also remember that the downgrade isn’t only based on the current situation, it is based on the bleak future prospects of the American economy. The S&P does not believe the American economy will recover from the damage Obama has caused any time soon. And sadly, I think they’re right.

There is much more to be said, and I will certainly write more about this subject another time. But for now, this is enough. If you have any questions or feedback, feel free to leave a comment. Thank you for reading.

John Gustavsson

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Anonymous said...

Thanks for posting this, John! This was very helpful in explaining how this actual effects the US, the world, and me. Well done, comrade!

BOSMAN said...

Excellent Post John.

Ohio JOE said...

Great article. While it is a bad situation, I cannot help, but see the humor in it. This is TARP all over again. The elite told us that we needed TARP, but it back-fired. Now, we were told we needed to raise the debt ceiling. We raised it and it back-fired again. Haha, ya gotta love it.