Stephen Foley: Everything changes in global financial markets if there's a credit-rating cut
Saturday 16 July 2011
US Outlook: Less than three years after the collapse of Lehman Brothers, a second financial crisis is now more likely than not. Against the backdrop of calm equity markets and a positively sanguine bond market, I know this makes me sound like Chicken Little. But let me explain.
Successive statements by the two largest credit-rating agencies have made it much more likely that the United States government will have its credit-rating cut, regardless of whether the country's politicians agree to raise the debt ceiling before the money runs out on 2 August.
This week, even Barack Obama appeared to give up on getting a "big deal" to cut $4trn (£2.5trn) from the federal budget. But on Thursday night, in what could one day be known as the shot heard around the world, Standard & Poor's suggested that a $4trn deal is the only thing that can prevent it cutting from its AAA rating on US debt. We should fear a downgrade of the US credit rating even more than we fear a US default on its debts. Few doubt there will be significant macroeconomic consequences from a downgrade: the US government will have to pay more for long-term debt in the future, interest rates will rise for businesses and families, and the world's largest economy could shift from weak recovery back into recession.
But the macroeconomic consequences, dire though they may be, are not what really scare me.
AAA-rated US Treasuries underpin trillions of dollars of financial transactions and the removal of that gold-plated rating, at a stroke, changes everything in global financial markets. It was these "micro" consequences, not the "macro" effects, that JPMorgan Chase's chief executive Jamie Dimon was talking about this week when he said: "No one can tell me with certainty that a US default wouldn't cause catastrophe."
Ben Bernanke, the Federal Reserve chairman, was talking about the consequences of a default when he predicted "possible chaos" in financial markets, but his words apply equally to a downgrade by the rating agencies. "Treasury securities are critical to the entire financial system. They are used in many different ways," he told Congress on Wednesday.
JP Morgan estimates that more than $4trn of Treasuries – nearly half of the outstanding stock – are used as collateral for the repo agreements that banks use as short-term funding and for derivatives trading through clearing houses and between banks. A downgrade from AAA implies at the very least that counterparties will have to tighten their terms, which could lead to financial distress for some borrowers and will certainly lead to a blizzard of dangerous rumours about who might be in trouble.
Worse, a lot of these transactions may require AAA-rated collateral, implying a collapse in demand for Treasuries and vast uncertainty in funding markets.
Pension funds and other conservative investors are among the biggest buyers of Treasuries because they are seen as the ultimate risk-free asset. Fund managers may personally think that Treasuries are no more dangerous as an AA-rated asset than they were at AAA, but they may still have no choice but to dump them. An unquantifiable number of funds will have mandates from investors that ban them from holding lower-rated assets.
The AAA rating is also why money-market funds – used by ordinary Americans and big businesses almost as if they are current accounts – hold $760bn of US Treasuries and related debt. Any sharp fall in Treasuries prices could lead some funds to "break the buck" and trigger a repeat of the run on money-market funds that we saw after Lehman Brothers in 2008.
As we saw time and again as the last financial crisis was developing, credit-rating downgrades have consequences, many of them mandated by law and regulations and often unforeseeable. Economists and traders have very sophisticated macroeconomic models that are good at solving a price for an AA-rated US Treasury bill; what they did not have in 2008, and still do not have, are models for predicting the consequences for liquidity in the financial system when every financial institution has to react to a big change all at once.
What can we say for sure? Two things. The micro consequences of a downgrade are uncertain. And nothing causes financial markets to panic like the sudden removal of certainty.
Will Standard & Poor's, or its rivals Moody's and Fitch, really pull the rug from underneath global finance? In the eurozone, they have certainly shown themselves to be unimpressed by bailout fudges and immune to political pressure. Now, partly in competition with each other, so as to be seen as the firm that got out ahead of events, these Great Powers are positioning themselves in ways that makes a US downgrade seem more likely than not.
On Wednesday, Moody's said it will downgrade the US if there is a default and the downgrade will not be quickly reversed. S&P said the same thing the next day, but it went further and tied the security of the AAA rating to a credible, long-term deficit-reduction plan. A $4trn deal would do. It did not specify a lower limit. It also said it would maintain the AAA rating at least into the autumn if the prospects of a big deal were kept alive on Capitol Hill.
Just raising the debt ceiling, without a deal it judges "sufficient to stabilise the US's medium-term debt dynamics", would trigger a downgrade, it said. Yet that is precisely the outcome that Washington now seems to be working towards.
In order to push the politicians, S&P is boxing itself into more and more aggressive rating actions, while the polarised politicians themselves appear boxed into a modest deficit-reduction deal or no deal at all. A calamity may already be pre-ordained.
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