What the US downgrade tells us about new world in debt
I was originally trained as a lending banker in the happy days of Barclays Bank International Limited or Beebeeeye to its staff. It was there that I learnt that a loan was only to be celebrated on the day it was repaid. Although we enjoyed upfront fees, there was no question of what the objective was.
I carried this apparently outmoded view of lending into the bond market and have always maintained that if a bond pays timely coupons and is repaid at par on redemption date, then it has done what it says on the tin. As such, any bond that fulfils the requirement is Triple A on maturity date, irrespective of what ratings it has carried during its lifetime.
Bond ratings tell us very little other than the statistical probability that the borrower will be able to meet his obligations on the due dates, be that by way of coupon payments or repayment of principal. It is here that Standard and Poor’s finds itself in conflict with the White House and with the Treasury. There is little doubt that, once the debt ceiling had been raised that Uncle Sam would be more than capable of meeting coupon obligations. In fact, it is likely that these obligations could have been met, in the short term at least, without the passage of the resolution.
However, we should have learnt that there is roll-over risk, the risk that maturing issues can not be refinanced. Given the staggering size of the American debt mountain there must, at some point, be the right, nay, duty to wonder what may happen at some given but as yet indeterminate point in the future when this might become difficult. If the answer to the question as to the United States’ ability to refinance any given amount at any time without let or hindrance is anything other than an unqualified affirmative, then S&P is right to raise its hand.
The President is not an analyst of credit so it is not for him to run around telling all and sundry that the country is AAA. A AA+ rating does not infer that the nation is about to default. Political shenanigans aside, the financial flexibility and tax-raising ability of Washington remains substantial but the rate at which borrowing continues to rise and outstrip revenues renders it more vulnerable to future roll-over risk.
Asian savings are funding the US deficit; it’s as simple as that, whether you like it or not. Should the Chinese really begin to consume like Americans, perish the thought, then those savings may no longer be there and things could become quite possibly a little bit sticky. The downgrade is telling us no more than that.
Confused and childish markets
Markets appear to have behaved pretty childishly of late. Although the S&P downgrade, first the anticipation, then the fact is merrily being blamed for more or less all of the volatility, it could be argued that the correction in asset prices was long overdue and that the great rally since March 2009 had been built on some mistaken belief that the post-Lehman world is just like the the pre-Lehman world, just without Lehman. That is not so.
Financial leverage and hence the ability to fund debt has been declining faster than debt itself and public sector debt has seemingly been increasing faster than private sector debt is being repaid. However, the most troubling feature is that it is patently clear that equity markets haven’t understood even the most rudimentary mechanics of credit and debt markets and the meaning of credit ratings.
The authorities have been calling for a simpler, less leveraged financial system. Well, they have it now. The style of liquidity which we (and they) became accustomed to in the first decade was a creation of lax supervision and cheap leverage. This has now gone and will, if the Crash of ’29 is anything to go by, be absent for a generation. Borrowers, lenders, capital raisers and shareholders – but most of all governments – will have to learn that there is only so much cash on the planet and it will have to be shared around. Until this process is more advanced than it is, which could take some years yet, value will be no more than a word in dictionary.