US downgrade and S.&P. $2 trillion mistake!

S.&P. Downgrades Debt Rating of U.S. is an overkill and kind of a face-saver with no real bite other then initial sell off of 7.5%-10%. Rating agencies have been trying to reinstate their reliability since last financial contagion, their crazily buoyant models led them to give AAA ratings to complex mortgage derivatives that later buckled. Rating agencies cannot measure with any precision the disparity in credit risk between a AAA and a AA sovereign. A downgrade from AAA to AA does not imply a significantly superior risk of default.

Is it politically motivated to hurt Obama prospects? May be not but Hamlet Act 1, scene 4, 87–91 comes to my mind:

Horatio: He waxes desperate with imagination.

Marcellus: Let’s follow. ‘Tis not fit thus to obey him.

Horatio: Have after. To what issue will this come?

Marcellus:Something is rotten in the state of Denmark.

Horatio: Heaven will direct it.

Marcellus: Nay, let’s follow him.

Moody’s defines probability of default over a ten-year horizon and the expected default at these levels is 0.0% at Aaa and 0.1% at Aa1. The ‘assumptions’ of a rating agency are extremely important and if these are pessimistically projected there is all the possibility of ‘downgrade’ mathematically. Japan was downgraded in the late eighties, it is still a safe haven for investors and strangely enough Fitch and Moody’s have not downgraded the US debt. The divergence of views of the rating agencies are very obvious to all who work in debt markets.

S.&P. downgrade may actually lower the 10 year yields as flight to safety may encourage investors to take money out of equities and riskier assets into the treasuries. It will hurt new credit, new businesses and new lending potential of the banks eventually. The paradox of this downgrade cannot be ignored; funnily enough according to reports emanating from Washington on Friday S.& P. informed the Treasury that it intended to issue a downgrade after the markets closed, and sent the department a copy of the announcement, a standard practice. Treasury noticed a $2 trillion mistake within the hour.

The Treasury called the company and explained the problem. About an hour later, the company conceded the problem but did not indicate how it planned to proceed, the official said. Hours later, S.& P. issued a revised release with new numbers but the same conclusion. On early Saturday morning, Standard & Poor’s said the difference could be attributed to a “change in assumptions” in its methodology but that it had “no impact on the rating decision.”

From their exotic valuations of the past Lehman ratings; I am a bit concerned when I see that S.&P. “change in assumptions “can lead to what Treasury noticing and calling a $2 trillion mistake! One can comfortably argue that there are signs in this $2 trillion that S.&P. is leaning on the side of caution far too much? The exotic modelling that gave mortgage backed securities rosy valuations in 2007 may have stretched their prudence a little too much. Telltale signature of an over vigilant ‘tea party’ mind set analysts pulling their strings at work? Analysts are human and have their own biases otherwise you don’t send numbers out with $ 2 trillion mistake and you don’t call them as change of assumptions mistake.

S.&P required the Congress to agree to increase the government’s borrowing limit and adopt a long-term plan for reducing its debts by at least $4 trillion over the next decade. Congressional compromise that President Obama signed into law raises the debt ceiling but reduced the debt by only $2.1 trillion.

Their failure to model systemic risk in 2007 due to the sheer size of the OTC markets over $603 tn from financial derivatives was a far bigger omission if correlated movements in the underlying of derivatives, interest rates, exchanges rates, sovereign debt etc that trigger multiple obligations are added. Unlike Fed the backers of those derivatives just packed up e.g. Lehman Brothers!

This is an over ambitious reach out to save face but may it back fires, because Fed as lender of last resort has ability to counter their action. US sovereign debt cannot be seen in isolation and is a minuscule part of the ‘off balance sheet liabilities that uphold the entire global financial system. With Fed as a banker of last resort providing bottom to the US treasury anyway the debt relegation bite is gone. Since the Federal Reserve continues accepting the government debt from the banks as collateral to borrow money as they have announced last night it leaves a downgrade with only figurative implication, the only clear monetary implication could be yields inching some notches higher initially on the 30 years Treasury bills and reversing back to even lower as investors pull out from riskier assets into the ‘safety’ of only the prime assets.

$ denominated global commodity and trade cannot be affected overnight by this rating drop nor will be the attitudes of the Chinese and other major holders of $. There is no other place to park their forex deposits. Fed has clearly announced and said that the decision would not influence the capability of banks by pledging government debt as collateral, such a statement has set the pitch for the response of the markets on Monday. What is the meaning of a downgrade from AAA to AA to the other global players like EEC, France and Germany?

There is no much statistical difference between a AAA and a AA, now that we all know that they had made an error of assumption of $ 2 trillion all this should downgrade be taken with a pinch of salt. Yet, this downgrade has opened a Pandora box for Europeans. The US downgrade will hit Europe as ironically, the downgrade of the US government raises genuine questions as to whether European governments with susceptible public finances and inadequate track record on debt consolidation and no Fed like experience of handling global contagions will remain rated AAA. France, UK are likely to suffer facing similar actions from rating agencies with growing likelihood of Italy and Spain downgrade by rating agencies.

The downgrade of the US government is more hurtful to Europe adding pressure on governments to move beyond their current crisis management approach in favor of the political and economic integration. Financial repression, monetization of the debt and eventual inflation was the result of a sovereign inability to pay their war reparations in case of Wiemar Republic, does US and Europe face similar fate is what the next few years shall determine, unfortunately the uncertainty is huge and so are the risks. The job of the US government and Obama is to stem this crisis of confidence by highlighting the possible recovery. There should be no politics with the jobs and future of a common man is involved, herein is a question of 300 million US citizens and they can produce and change the tide, growth and productivity settles all dues.

Overnight nothing has changed only an effort that may change the perception; there is no need of panic – this is not the beginning of a new contagion of 2011 but a harbinger of greater European integration and may be more monetary discipline! The volatility will be extremely high watch for it and may be some buying opportunity amidst calls of disaster. A return to robust growth is the change we need. Private sector entrepreneurs are the ones who can deliver it — if we are wise enough to set up the proper incentives for them to decide to get moving.

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