Thoughts on the downgrade

  • Are you really surprised? AAA debt is supposed to be the ultimate sleep insurance. You park your money there and don’t have to ever worry about it. You don’t have to think about it. It is completely, unquestionably safe. If you didn’t feel that way last weekend, you agree with S&P.
  • At the height of the negotiations, Treasury securities were never in peril. Even with default there was enough money to cover interest payments, and Dems and Reps agreed that securities would be paid. But the rating agencies have been clear that they would treat failure to meet any obligations as a default. So if the government met its interest payments but stiffed Grandma’s Social Security, that’s a default.
  • U.S. debt is still rated AAA, at least to most CFOs. As blogger/bond trader/actuary David Merkel points out, most corporate investors are interested in the average rating of S&P, Moody’s and Fitch – AA+/Aaa/AAA.
  • Other bond trader comments are here; basically there’s little consensus what will happen Monday.
  • I don’t think any technical analysis – meaning the number crunching of America’s ability to pay its debt – drove the downgrade. I say that because S&P continued with its downgrade despite what the Treasury Department called a $2 trillion error. Bloomberg reports that S&P disputed the size of the error, which it said was only $345B and continued with the downgrade anyhow.
  • If the math had driven the conclusion, S&P would have taken more time to check all of its calculations.
    Picture the situation at S&P moments after Treasury points out the $2 trillion error. (T found the error in an hour – pretty quick – which implies the error was glaring.)
    In the room is probably top S&P executives and the team of analyst/quants. The execs – who don’t know the guts of the calculation (they trust their analysts on the minutiae, as they should) – turn to the analysts and say, “Treasury says you have a $2 trillion error. How sure are you that you are right?”
    They continue: “I think you realize there is A LOT riding on this – a lot more than this firm’s reputation or your reputation or mine. Quite literally, the entire world is depending on your analysis. Treasury found an error in less than an hour. What else might you have wrong?”
    I’ve been in similar situation (lower stakes, obviously) and when the other side has blown a hole in your analysis, you pull your analysis back and re-check everything to the third decimal. With the financial markets closed for the weekend, there’s no reason to not pull back your analysis for 12 to 24 hours.
    But that didn’t happen. S&P threw Treasury a $345B bone and downgraded anyway. The math didn’t matter.
  • The downgrade reflects disgust at the American political system’s willingness to play too close to the cliff:
    “.  .  .  We have changed our view of the difficulties in bridging the gulf between the political parties over fiscal policy, which makes us pessimistic about the capacity of Congress and the Administration to be able to leverage their agreement this week into a broader fiscal consolidation plan that stabilizes the government’s debt dynamics any time soon.”

Update: Villains of the crisis here. More on the math error here.

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