As a follow-on to my last post, here’s a graphic courtesy of ThomsonReuters showing the credit rating of 126 of the world’s nations.
The full article is available here.
hat tip: Ritholtz.com
Jul 31th
Sovereign Ratings
While the rest of the world goes about its business and shakes its collective head in disgust with the political circus in DC, Wall Street (about which there’s surely plenty to shake one’s head) is captivated with the possibility that, if the government borrowing limit isn’t raised and there’s a postponement of payments from the Treasury, US Treasury debt will be downgraded by Moodys, Standard and Poors or other NRSROs (nationally-recognized statistical rating organizations.)
These ratings are provided by the NRSROs (borrowers pay for them, in fact, which is one of the many conflicts of interest that fueled the credit crisis from which we’re slowly recovering) to assist bond purchasers like yours truly with the heavy lifting of detailed credit analysis on each issue under consideration. Since borrowers with lower credit ratings are ostensibly riskier to which to lend, the interest rate on their bonds is higher than those of higher quality bonds (all other things equal.)
Wall Street’s morbid fascination, then, is around the question of “what happens if the world’s ’safest’ security is no longer so?”
PIMCO’s Neel Kashkari penned a short piece in today’s Washington Post that deserves a read by anyone trying to understand why the deletion of one letter – AAA to AA – might be such a big deal. His highlights:
- A downgrade of U.S. credit could spark a new financial crisis. The question is: Would the impact be as great as when Lehman Bros. failed?
- Treasuries have been defined for decades as the risk-free financial instrument throughout global financial markets; faith in them is far stronger than it was in debt of Lehman.
- U.S. Treasuries are a $14 trillion market. Lehman had approximately $600 billion of liabilities before it failed, less than 5% of the size of the Treasury market.
These factors suggest that a U.S. downgrade has the potential to be as bad, or perhaps worse, than the Lehman shock.
The full article is here.
In my opinion, the government (I include both the Legislative and Administrative branches here) has demonstrated itself to be almost completely incompetent at one of its main tasks – the management of the public purse. The Tea Party and others deeply concerned about the US debt levels and growing deficit have thrust those questions squarely into the spotlight. While I disagree with much of their platform, I must give them credit for elevating the attention paid to the topic, which scarcely received a mention in the last Presidential election. Unfortunately, the level of discourse has gone the opposite direction, leaving the President and Congressional leaders at an apparent impasse and the rest of us baffled, frustrated and disgusted.
Kashkari’s article attempts to plumb the size of the potential market disruption, the first well-reasoned research I’ve seen on the subject. He doesn’t discuss, however, other potential impacts, such as the valuation ripple effect from:
- Having the sovereign rating drop below that of companies based in the US - Will those corporations have their debt ratings cut too, since a country that can fund itself through taxes is theoretically a better risk than any company that must rely on selling its goods or services?
- Having US rated lower than other countries - Will capital flee the US for, say, Germany, and create a run on Bunds (and a sharp boost in the Euro, which wouldn’t be helpful for Germany’s large export sector)?
- Potential regulatory policy changes – Many banks, pension funds, investment companies, etc. are required to invest in AAA-rated bonds or Treasuries. Will banking or pension regulations be rewritten to allow for this unforeseen policy variance?
There’s a very good argument to be made that NRSRO’s should not be allowed to hold the US economy hostage. They were, as I noted, one of the key villains in the credit debacle, and it’s no leap of logic that after facing the wrath of Congress and the Administration they’re enjoying having those politicians over the proverbial barrel. However, this is how the structure currently stands; we must deal with reality as it is, not as we wish it were. Truth be told, if I were in charge of making the call (and didn’t have to worry about the above-mentioned fallout) I’d have already downgraded US debt: timely repayment of principal and interest should never be in question for AAA-rated bonds. The US no longer meets that standard.
It’s surely possible, too, that since the US bond market remains the largest and most liquid by far, China, banks, individuals and other investors may go right on buying them as before, essentially ignoring the lower credit rating. We can hope…
Jun 23th
What Remains in the Fed’s Toolkit?
As most know, the Fed’s $600 billion program of purchasing Treasury bonds, known as QE2, is coming to an end within a few days. Recent US economic data has been decidedly weak, leaving some wondering if the Fed’s monetary policy toolkit is now empty.
Economist Joseph Brusuelas from Bloomberg yesterday penned an article considering the options remaining available to the Fed if, as is feared by some, the US economy slips into a double-dip recession or deflationary environment. According to Brusuelas, the FOMC’s options (listed roughly in order of severity) include:
- Committing to keep policy rates a very low for a specific period of time. The Fed has implicitly done this, since they’ve used the “extended period of time” phrase in their meeting minutes for over two years.
- Making explicit its implied inflation target of 2%.
- Maintaining its balance sheet at or near current levels for a specific period of time.
- Reducing the interest paid on reserves held at the Fed to 0% from the current 0.25%.
- Imposing a penalty on excess reserves held at the Fed.
- Capping yields.
Jun 23th
The Coming Storm
While I hadn’t done any real studying of the issue, it seemed to me as though we’ve recently witnessed a lot of natural disasters. Recovering from them has laid an even heavier burden on those who’re trying to recover from the man-made disaster called our economy.
Turns out that the Society of Actuaries has done the studying of that topic for me. The SOA’s June 2011 bulletin, entitled “The Coming Storm – Natural Disasters and a Struggling Economy”, offers several ominous observations:
Actuary Shaun Wang, a leader in enterprise risk management, and founder and Chairman of Risk Lighthouse LLC, warns of a “perfect storm,” a combination of natural disasters on a scale even larger than the Japan earthquake coupled with a second-dip market meltdown greater than the 2008 financial crisis.
- Four of the five costliest earthquakes and tsunamis of the last 30 years have occurred in the last 13 months. Conditional probability of an earthquake in the northwest U.S. has increased significantly due to changing pressures on crustal plates.
- The world is on the brink of a severe shortage of food and water. Thanks to a new peak population of nearly seven billion, demand is outpacing supply. Severe drought and water scarcity would affect food availability and cause spikes in food prices.
- Warnings of solar flares from a “huge space storm” came to fruition on June 7, when NASA reported a potent blast from the Sun causing a firestorm of radiation on a level not seen since 2006. Flares such as this have the potential to disrupt satellite communications and power on Earth.
This “perfect storm” would almost certainly trigger a market meltdown, shocking an already fragile U.S. and world economy.
The entire bulletin is here.
Jun 17th
Beware of Greeks Bearing Horses
I haven’t written much, recently at least, about the continuing drama in the Eurozone. In early 2010 when the story first broke, Kevin and I commented in several pieces (here, here, here, here, and here), and I was interviewed on local television as the riots in Greece first erupted (see video here). In short, it was pretty obvious a year ago that the problems in Greece and many other European nations weren’t going away easily or soon. My guess is that they’ll get past this crisis by a combination of austerity (both elective, at least on the part of grim and shell-shocked politicians, and forced, via the bond market) and “kicking the can down the road”, continuing the time-honored tradition of avoiding a crisis only to set the stage for greater calamity in the future.
That said, I learned today, from the blog of comedian Andy Borowitz, the Greek government may have hit upon a unique way of repaying their debts: A giant horse.
Greece Offers to Repay Loans with Giant Horse
Steed Wheeled Into Brussels at Night
BRUSSELS (The Borowitz Report) – In what many are hailing as a breakthrough solution to Greece’s crippling debt crisis, Greece today offered to repay loans from the European Union nations by giving them a gigantic horse.
Finance ministers from sixteen EU nations awoke in Brussels this morning to find that a huge wooden horse had been wheeled into the city center overnight.
The horse, measuring several stories in height, drew mixed responses from the finance ministers, many of whom said they would have preferred a cash repayment of the EU’s bailout.
But German Chancellor Andrea Merkel said she “welcomed the beautiful wooden horse,” adding, “What harm could it possibly do?”
Joe Nocera, a great columnist at the NY Times, recently published an interview with M&T Bank’s CEO, Robert Wilmers. To be blunt, it would be impossible for me to agree more with Wilmers’ observations. Rather than dilute Nocera’s excellent prose I’ll simply quote a few passages:
- In the run-up to the financial crisis, the giant national banks — which he viewed as a distinct species from the typical American bank — had done things that deserved condemnation. And, he added, “They are still doing things that I don’t think are very good.”
- “It has become a virtual casino,” he replied. “To me, banks exist for people to keep their liquid income, and also to finance trade and commerce.” Yet the six largest holding companies, which made a combined $75 billion last year, had $56 billion in trading revenues. “If you assume, as I do, that trading revenues go straight to the bottom line, that means that trading, not lending, is how they make most of their money,” he said.
- …Banks were taking excessive risks that were never really envisioned when the government began insuring deposits.
- …Bank C.E.O.’s were being compensated in no small part on their trading profits — which gave them every incentive to keep taking those excessive risks.
- Finally — and this is what particularly galled him — trading derivatives and other securities really had nothing to do with the underlying purpose of banking.
The entire article is here.
hat tip: Ritholtz.com
May 20th
They Said It, I Didn’t
Although I don’t disagree…
Today from NPR’s Planet Money series (one of the better pieces of investigative / educational journalism extant):
Gold: The 4,000-Year-Old Bubble
Read and/or listen to the story here.
My earlier thoughts on gold (soon to be updated).
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UPDATE: Tuesday 24 May 2011
Column in today’s NY Times amplifies the point made by the NPR story, and in my earlier scribblings:
My impression is that not that many experienced practitioners, including yours truly, slavishly subscribe to the doctrine after it’s been shot full of holes past few years, but for those of us raised on Modern Portfolio Theory it’s dogmatic that US Treasury bonds are THE credit risk-free asset that underpins valuation calculations for everything else. I mean, EVERYTHING else – stocks, bonds, commodities, whatever, fair value calculations start with a risk-free rate to which risk premia are added.
Caused me to do a double-take, then, when I saw this graphs from the IMF (not some tin-hat blogger like yours truly, the IMF!) that shows a credit premium – the pink area on the graph – beginning to appear, according to their models in 2008.
On the other hand, anyone who’s not been on another planet, in a CIA black-ops prison or a coma knows that the gold ol’ US Treasury note just isn’t what it used to be (case in point, S&P’s spectacularly un-newsworthy downgrade of US debt - that horse is so far out of the barn he’s over the horizon and in the next county).
An excellent write-up of the graph and related info is on Barry Ritholtz “The Big Picture” blog.
Editor’s note: I no longer subscribe to the MPT / EMH doctrine as it was taught nearly 20 years ago when I waded through the CFA program. Sometimes you have to learn the theory so you can understand why it doesn’t always work in practice…
Hat tip: Global Macro Monitor for the graph
Apr 22th
Like Lehman All Over Again
Remember the shockwaves created by Lehman’s collapse in September 2008? (I certainly do – I phoned from the Sawtooth wilderness to coach my panicking then-employer how to buy 1 week T-bills at negative interest rates.) While it’s a little hyperbolic, Annie Lowry’s piece in today’s Slate.com proposes a similar global market reaction if the US defaults on its Treasury debt.
Among the cascade of problems she foresees on that fateful day:
- sharply higher interest rates
- dumping of Treasuries onto skittish global bond markets, fueling a “run on the bank” similar to Sept ‘08
- widening of the repo “haircut” that causes further evaporation of market liquidity
- collateral calls on projects where Treasuries were presented as collateral
- money market funds “breaking the buck”, and subsequent massive withdrawal of investor funds from that market
I’d add to the list the headache of bank capital and liquidity levels coming into question since many financial institutions maintain large Treasury note positions. Municipalities, pension funds and other large institutional investors are also required to hold certain percentages of their pools in high quality assets, so would feel the effect of deteriorating credit quality (not to mention the painful price markdown.)
Read the full article here.
ADDENDUM 5.38pm MST, 25 APRIL 11: A JP Morgan research piece echoing most of Lowry’s points can be read here -> JPM Domino Effect
Aug 07th
Once In A Lifetime
Author: Kenn Lamson
Comments: 0
I’ve checked off a few once-in-a-lifetime boxes at age 45: As a goggle-eyed kid I watched Neil Armstrong step onto the moon, several years later wore my most patriotic red/white/blue shirt (with red socks!) to celebrate our nation’s 200th birthday, strode across the stage for high school and collegiate graduation (as many do – I didn’t say this was an exclusive list!), got married and divorced (the latter of which I hope will only be once), and so on. As of Friday afternoon, however, I unfortunately must add to that list of once-in-a-lifetime occurences that I’ve witnessed the downgrade by Standard & Poors of the US sovereign credit rating.
In my earlier posts I mentioned a few of the questions now standing front-and-center before the markets and investors. While anyone who says they know what will happen tomorrow and in subsequent days should be dismissed out of hand, I offer below commentary from some of those I read and respect:
Financial Times: S&P Cuts US Debt Rating to AA+
Economist: S&P’s Credit Rating Cut: Downgrading Our Politics
PIMCOs Mohamed El-Erian: US Downgrade Heralds a New Financial Era
NPR’s Planet Money: Why S&P’s Downgrade of the US Credit Rating May Not Be As Bad As It Sounds
Barry Ritholtz: 10 Questions About the S&P Downgrade
As I write this on Sunday afternoon several firms with typically insightful commentary have not opined since S&P’s action, so I’ll append the post as other comments become available.
UPDATE 9:30PM MONDAY 8 AUGUST 2011:
As the market reopened today (and took a 6.7% shellacking) additional firms shared their assessment.
Vanguard: Downgrade Should Mean Little for Long-term Investors
Absolute Return Partners: Why The US of AA Matters
QB Asset Management: Downgrade of US Treasury Obligations Legitimate and Insufficient (hat tip Ritholtz.com)
Paul Kasriel (Northern Trust): S&P’s Downgrade of US Sovereign Debt – People Actually Pay Them For These Opinions?
John Hussman: Recession Warning and the Proper Policy Response