S&Ps Downgrade of USAs AAA Credit Rating

August 3, 2011

Naufal Sanaullah
naufal.sanaullah@gmail.com

S&PS DOWNGRADE OF USAA AAA CREDIT RATING

The USA AAA rating Was it justified economically? Had the market priced in a cut? (How) will this technically affect supply and demand in the near term? Long term prospects Foreign creditor Treasury holdings S&Ps rate cut Why now? Miscalculations? White House vs S&P Political fallout Potential trades

THE AAA RATING

WAS IT JUSTIFIED ECONOMICALLY?

US at minimal economic risk of default because:
Debt is primarily denominated in domestic currency, of which the Federal Reserve is a monopoly issuer Recent accounting changes allow the Fed to buy securities and sell them in a higher interest rate environment without solvency issues (at least near-term)

Grim prospects for global growth likely to keep borrowing costs low near-term Interest expense rising on federal level, could spread to state & local levels as well Economically, default risk as close to zero as exists in the current global financial system, strictly as a function of the Feds capabilities Ignoring the Feds unique position, the US economy probably does warrant a less than per fect credit rating

US INTEREST EXPENSE TO GDP

4.5 4 3.5 3 Percent of GDP 2.5 2 1.5 1 0.5 0 1920 1930 1940 1950 1960 1970 Year State Local Federal Total 1980 1990 2000 2010

HAD THE MARKET PRICED IN A CUT?

The markets reaction to the debt ceiling debacle and S&P credit rating downgrade watch was a repricing of growth rather than solvency Prospects of austerity dampened growth expectations Demand for cash and liquidity also helped bid USTs up significantly
T-bill scarcity is giving banks a hard time to provide non-negative yields on mass influx of deposits Banks essentially seeing hot money temporary flows into safe havens

CME announced 50bps haircut on formerly risk-free bills almost two weeks before S&P downgraded Risk is selling off because of policy divisiveness and political inaction:
GOP vs White House/Dems Germany/core vs periphery

S&P 500

April 29: Sarah Palin s ay s h e l l s n o to raising the debt ceiling

July 22: Obama-Boehner negotiations collapse

April 18: S&P assigns negative outlook to USA July 14: S&P places USA AAA rating on CreditWatch negative, says it could downgrade credit as soon as within the month July 31: Boehner releases details of proposed agreement, passed by the House the next day, and the Senate the day after that

10YR TREASURY YIELD

April 29: Sarah Palin s ay s h e l l s n o to raising the debt ceiling

July 22: Obama-Boehner negotiations collapse

April 18: S&P assigns negative outlook to USA AAA rating

July 14: S&P places USA on CreditWatch negative, says it could downgrade credit as soon as within the month

July 31: Boehner releases details of proposed agreement, passed by the House the next day, and the Senate the day after that

(HOW) WILL THIS TECHNICALLY AFFECT SUPPLY AND DEMAND IN THE NEAR TERM?
For risk-based capital purposes, the risk weights for Treasur y securities and other securities issued or guaranteed by the U.S. government, government agencies, and government-sponsored entities will not change. -Fed/OCC/FDIC/NCUA Funds with risk mandates can still consider US Tsys AAA until: S&P cuts the credit rating further (the rating does carry a negative outlook requiring substantive action in order to maintain AA+) Moodys and/or Fitch also cut the USs long term rating (unlikely in the near term) A+ rating maintained on shor t-term debt means ratings cut is no risk to money markets Ef fects do exist in terms of risk modeling There are immediate operational consequences, from re-coding risk and trading systems to evaluating collateral and liquidity management. Mohamed El-Erian, PIMCO

(HOW) WILL THIS TECHNICALLY AFFECT SUPPLY AND DEMAND IN THE NEAR TERM?
UK & France will be in markets scope for imminent S&P downgrades; US downgrade may spark selling in French & UK govys With Frances markets fur ther deteriorating, Germany will be unable to bear the brunt of the costs required to backstop Italy and Spain ECB looks increasingly likely to be lender of last resor t here; S&P downgrade could be catalyst for increased ECB involvement/ inter vention in European debt crisis If ECB does not come introduce large-scale measures, the European system may face acute stress and countries may approach insolvency If UK yields star t rising based of f of fresh credit rating downgrade risk , negative implications on growth in a fiscal austerity environment could lead to Bank of England renewing easing rhetoric in for thcoming oppor tunities Renewed downgrade risk premia in munis? Dollar liquidity likely to remain tight and possibly tighten fur ther; crash risk is high

GLOBAL SHORT-TERM LIQUIDIT Y TIGHTENING?

Fore ign financial CP out st anding v s US Dollar T WI ( inver se)

LONG-TERM PROSPECTS
Recalibration of safe havens, which was a theme in my piece from last week, is likely in play even more so after this ratings downgrade More flows into precious metals and CHF as safe havens Long-term flows out of USD-denominated assets Risk premia should also spread to other AAA rated countries in danger of seeing a ratings downgrade from S&P, eg France, UK Likely to be ver y bearish for banks and insurance firms Likely to have large cultural and societal implications Public frustration with economy spiking just as Congressional approval plunges The center is increasingly distanced from both parties Western nations now also seeing popular discontent with government and authority, eg Tottenham riot

LONG-TERM PROSPECTS
Also sets up for per vasive reassessment of the role played by credit rating agencies in the financial system The AAA downgrade could end up being a trigger that sets of f a new dynamic rebalancing of risk on a longer term, gradual perspective; shif t from risk-on/risk-of f to high growth/low growth (growth with respect to GDP) Is the USD still a safety asset? Is it still going to be in demand during flights to quality/safety? Risk of China dumping bonds is minimal Chinas UST holdings are a function of its trade policy/growth model, not a directional investment With the USs AAA ratings downgrade being more acutely bearish for Europe than America, what other liquid instruments can be used to diversify out of USD? Will this go down as a Sputnik moment or the harbinger of a structural decline?

S&PS RATE CUT

WHY NOW?
April 18: We believe there is a material risk that U.S. policymakers might not reach an agreement on how to address medium- and long-term budgetar y challenges by 2013; if an agreement is not reached and meaningful implementation is not begun by then, this would in our view render the U.S. fiscal profile meaningfully weaker than that of peer 'AAA sovereigns. S&P July 14: The CreditWatch placement of the U.S. sovereign ratings signals our view that, owing to the dynamics of the political debate on the debt ceiling, there is at least a one-intwo likelihood that we may lower the long-term rating on the U.S. within the next 90 days. S&P The politics of DC and the debt ceiling timeline are what drove the timeline of S&Ps announcements as well

MISCALCULATIONS?
S&P released a judgment about the credit rating of the U.S. that was based on a $2 trillion mistake. John Bellows, US Treasur y Af ter acknowledging the error, S&P removed a prominent discussion of the economic justification from their document and refocused the downgrade argument on the politics Implications on debt/GDP ratios displayed on the char t to the right, cour tesy of the US Treasur y

WHITE HOUSE VS S&P

In April, Secretary of the Treasury Timothy Geithner said that there no risk of downgrade of the USs AAA rating The Treasury is directly attacking S&P over its ratings downgrade and mathematical error The GOP is likely to use the downgrade as a focal point around which to blame the Obama administration for economic woes President Obama and the White House are likely to pass the blame off to S&P and rally around negative populist sentiment of credit rating agencies

WHITE HOUSE VS S&P

Dodd-Frank had negative implications on CRAs In March, congressional Republicans launched the first real push for Dodd-Frank reform, including a proposal to limit CRA liability on previous ratings White House and Democrats likely to frame debate around the merits and roles of the CRAs and try to de-legitimize the downgrade Look for the political rhetoric to heat up further

POLITICAL FALLOUT
Because of the increased risk premia that the UK and France will now face as a result of US losing AAA, a coalition of such nations could begin an attempt at fundamental reform of the CRA industry to minimize their ratings impacts CRAs likely to face even more populist frustration & blame and regulatory uncertainties than they face presently Likely to have implications on munis; potential downgrades in state & local debt are possibly imminent Political fallout of rating cut likely to be more acute in Europe Emergency calls being held by ECB & G20
Coordinated policy response before market open? Will the ECB relent on its hawkish policy?

Because of the knock-on effects to France, the EFSF finds newfound funding uncertainties

POLITICAL FALLOUT
German government is already saying Italy is too big for an EFSF bailout and that an Italian bailout would negatively af fect German finances This is Germany posturing against unilateral backstopping ECB may have to convert its stopgap plan of SMP Italian bond purchases into a much larger, more per vasive, unsterilized one ECB could always cut rates as wellwhich the Germans may be more willing to allow, as it is a better alternative to Germany bailing out the rest of Europe itself Still, Bundesbank President Jens Weidmann is opposed to bond purchases This sets up for the potential for an acute monetary crisis that could destabilize markets With Weidmann and Stark opposing bond buys, are we approaching a breakdown/inflection point?

POLITICAL FALLOUT
Asia may not be behind the periphery bid without ECB backstopping the market and system A return to the Deutsche Mark at a fixed exchange rate to the Euro has been another idea making the rounds that may become more realistic as the European crisis intensifies With Italy sovereign credit rating review by S&P forthcoming, the European crisis is becoming more acute, especially with the prospect of a double notch downgrade of Italian debt US AA+ rating is on negative outlook as well, so status quo insufficient for maintaining AA+ from S&P Similarities to 1937-38 global double dip increasing

POLITICAL FALLOUT
Downgrade bodes poorly for the already increasing divisiveness between political par ties Obamas action on Geithner will be scrutinized
Geithner recently wanted out and Obama convinced him to stay onboard Post-downgrade, there are already calls from GOP politicians to fire Geithner Obama may have to double up on his bet on Geithner in order to shift blame of the downgrades implications on the GOP and S&P Jon Corzine potential replacement for Treasury Secretary?

What will be the regulator y impact on CRAs? Will the Fed, BoE, or ECB announce easing going for ward? What will Congress do between now and November 23/December 23 (deadlines for agreement on additional BCA savings and for Congress to pass them)? Government debtor vs creditor divisiveness going for ward?

POTENTIAL TRADES

POTENTIAL TRADES BASED ON THE US SOVEREIGN RATING DOWNGRADE

All of these trade ideas are invalidated in the event of a large enough scale policy response from G7, G20, or ECB before markets open Sunday night Safe haven repricing Long precious metals Long CHF (vs USD, EUR, GBP, JPY) Long big-cap multinationals with large cash reserves (especially ones with dividends) Knock-on ef fects for Europe Short European banks and insurers Short EUR (vs USD, CHF, JPY) Long CHF vs HUF, PLN Long periphery debt on yield spikes (once/if reversal back down is underway) Short bunds and French govys vs long USTs

POTENTIAL TRADES BASED ON THE US SOVEREIGN RATING DOWNGRADE

UST bid, but longer-term credit risk rising Long 10s30s bull steepener Long short end of Tsy curve Financial system weaker without AAA rating to back its most liquid reserve and funding currency/regulatory uncertainties for financial sector Short BAC, C, WFC, GS, JPM, STT, MS Short MHP, MCO Deteriorating prospects for government expenditures and investment globally Short coal and steel equities Short copper and AUD Short shipping equities

CHARTING 10YR NOTE FUTURES

CHARTING 30YR BOND FUTURES