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…