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Wednesday, 18 October 2017

Turn of the century

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It is not clear yet if the US Congress will raise the nation’s debt ceiling in time to avoid a default, but the country’s gilt-edged credit rating is clearly now vulnerable to a downgrade, and that is going to have a lasting effect, regardless of the outcome in Washington.

Imagine that another country was threatening to default out of choice – and imagine what the President, congressmen and senators would say if that country owed money to the US. The volume would be deafening as US officialdom made the most of its bully pulpit to demand that the nation in question lived up to its obligations. They would point out that no internal dispute could possibly provide an excuse for threatening to default – and that such a decision would irreparably damage that country’s credibility.

They would be right, of course, and the same applies to the US.

The politicians’ refusal to compromise puts a spotlight on governmental weakness, and that reduces the confidence people need in order to engage in the risk-taking necessary for financial markets to function. Without confidence, there will be less investing, less lending and less borrowing. It will be a drag on capital formation.

A rating is a judgement of a borrower’s willingness and ability to pay its obligations. And while the yields investors are demanding to hold Treasury debt have not skyrocketed yet, a downgrade could change the role of Treasuries in the global financial system.

While it won’t be immediate, investors will start looking elsewhere for riskless investments. They have opportunities (though with far less volume and liquidity) in certain Triple A corporate, US munis and in other sovereigns. Those that find viable (if imperfect) substitutes, may not readily come back.

And aside from the cost to the US itself (and its taxpayers) this inaction by the country’s elected leadership will cost states and municipalities, consumers and corporations, and both institutional and individual investors. As one money manager said simply this week, “a downgrade really is unquantifiable”.

He predicted that mutual funds, swaps, brokerage agreements, repos and other arrangements that have investment guidelines in prospectuses and elsewhere about what securities can be held or posted as collateral will be rewritten. That kind of systemic change is not easily undone.

Riskless – once risky – can never be riskless again.

Once the financial markets infrastructure that has centred on the safety of Treasuries for the past 80 years begins to drift away, any decisions in Congress will be too little too late.

As emerging markets rise and the world looks elsewhere for leadership and opportunities, this battle over raising the US debt ceiling could very well be the point cited by historians as the moment the American Century ended.

Opportunity knocks

Despite this horrible backdrop, American investment banks have a once-in-a-generation opportunity staring them right in their faces. Yes, they may take some collateral damage from the problems in the States but they are likely to end up in a much stronger position than many of their European rivals.

Indeed, many European banks are walking wounded, hobbled by a massive drop-off in business, their exposure to the region’s ailing sovereigns and more stringent rules on pay. Coming months will probably see many forced to take hundreds of millions in write-downs linked to Greek debt.

For those US firms with big European ambitions, now is the time to strike. Many European banks will be forced to shrink their balance sheets in coming months and years, constraining their ability to win business. Not only will write-downs and lack of market activity take their toll, but many will also be forced to offload assets in the run-up to new Basel III rules. They are also shedding staff by the busload, meaning pickings are rich for banks willing to beef up.

For US banks willing to chance their arms, there is market share to be grabbed and suddenly neglected clients to pick up. These are risky times, but this is still an opportunity too good to be missed.

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