4 things to remember about the US downgrade

A few thoughts after a wild few days.

By Motley Fool Pick of the Day Aug 11, 2011 2:56PM

By Morgan Housel

 

After several days, a stock market plunge and a flurry of finger-pointing, we're still trying to figure out what Standard & Poor's downgrade of U.S. Treasurys really means. Here are four points to keep in mind.

 

1. It had no impact on Treasurys. The biggest risk of a Treasury downgrade was the possibility that interest rates would rise. That could add trillions to future federal borrowing costs and stifle economic growth.

 

But interest rates didn't rise at all after the downgrade. In fact, they've plunged. Monday turned out to be the eighth best day for 10-year Treasurys in modern history. The biggest irony of downgrading Treasurys is that it instantly increased global demand for . . . Treasurys. One blogger, mocking the stereotypical investor, quipped: "Treasurys were downgraded? Wow! Sell my entire stock portfolio and get me into Treasurys!"

 

How do you explain that? It's simple. The risk that led to the downgrade was political. But financially, Treasurys are still the safest, most liquid assets in the world. And the U.S. still has the means to pay its bills. That isn't a question. Investors still flock to Treasurys whenever there's a panic. It's where they feel safe. Incredibly, the Treasury can borrow money for 10 years today at less than half the interest rate offered a decade ago, when the government ran surpluses.

 

2. It will have no impact on banks. Banks are required to hold minimum levels of buffer (capital) against certain assets. Risky assets require big buffers, less-risky assets require smaller buffers, and Treasurys require basically no buffer at all, since they're considered risk-free.

 

That could have changed after the downgrade. Without a pristine credit rating, the rules regarding how much capital banks have to hold against Treasurys could have been rewritten, forcing them to scramble to raise more capital. This could have been gut-wrenching since Bank of America (BAC), Wells Fargo (WFC), Citigroup (C), Goldman Sachs (GS) and JPMorgan Chase (JPM) collectively own almost $1 trillion worth of government securities.

 

But within minutes of the downgrade, the Federal Reserve issued a statement making it clear: The downgrade will not change how much capital banks are required to hold against Treasurys. This was an incredibly important development that went largely unnoticed. Anything different could have sparked a banking panic. Be thankful for it.

 

3. The rating agencies' credibility is dubious. S&P downgraded the nation's credit because of political bickering. That political bickering is mostly about the massive accumulation of debt in recent years. And why has debt exploded in recent years? Because of the financial crisis. And who caused the financial crisis? If you had to come up with five broad culprits, the rating agencies would be one of them. We could not have had a housing bubble like we had without the rating agencies. And we wouldn't have today's deficits without a housing bubble.

 

Think of it that way, and S&P effectively downgraded itself.

 

Now, mentioning S&P's housing-bubble fumbles when criticizing the recent downgrade is misleading. While they work under the same roof, the analysts who rate housing bonds are not the same analysts who rate sovereign debt.

 

But there's another valid criticism beyond S&P's past performance. As I wrote Monday, S&P's original downgrade report had a glaring math error. When that error was corrected, the nation should have, by S&P's original standards, been in the clear for a stable credit rating. Instead, the revised report changed the benchmarks so that forecast deficits still fell into a danger zone.

 

The snafu underscores an important point: S&P's downgrade is the opinion of one very fallible group of people. It's outrageous to think that it should shift the path of the global economy.

 

4. If there's anyone to blame, it's us. S&P made it clear: The credit downgrade was mostly a demotion of our political system. Our deficits are large, but our political infighting is massive.

 

Motley Fool co-founder David Gardner asked an important question recently. Paraphrasing a famous Warren Buffett quote, he asked: "Would you be willing to put every last dollar you have into the hands of this particular public official to manage on behalf of our future?"

 

David didn't mean it literally. But "we stand a far greater chance of improving, rather than further undermining, our creditworthiness as a nation if we as its citizens begin to ask this Buffett question of ourselves prior to casting votes," he wrote.

 

I think you can take it a step further. A recent poll shows that just 14% of Americans approve of Congress' performance. Another showed most Americans would vote out every member of Congress, regardless of party, if they had the chance.

 

The amazing thing about that statistic: They do have the chance. They can vote.

 

Yet so many choose not to. In last year's elections, just 37.8% of the voting-age population made it to the polls. Thirty million more votes were cast for last season's "American Idol" than for last year's Congressional election.

 

Think about that. Most people who disapprove of Congress' performance don't even bother to vote. These people have very little right to complain, in my view.

 

If you're sick of what's been going on lately and are appalled about the credit downgrade and its impact on your investments, do something about it. Vote.

 

Fool contributor Morgan Housel owns Bank of America preferred. Follow him on Twitter @TMFHousel. The Motley Fool owns shares of JPMorgan Chase. The Fool owns shares of and has opened a short position on Bank of America. The Fool owns shares of and has created a ratio put spread position on Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

 

5Comments
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Terrific article. It is true what the author wrote, the credit rating agencies, created the housing bubble, by giving garbage subprime mortgages a AAA rating. Any thinking person, should ask themselves, how did  our Govt. and SEC a agency of our Gov. react when this occured? My personal opinion, it was all political, with our Government at that time. It was easier for our politicians to look the other way, then when they were running for reelection, they could use as part of there campaign speeches, that home ownership was at a all time high. It worked well for them, they got reelected in 2004. We are all paying for this, what I would call crookedness, with our bad economy and fallen home prices.  
Aug 12, 2011 1:19PM
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  Good observation,  We were do for some kind of backlash from the economic chaos of the last few years.  I'm optimistic that over time the economy will recover albeit a long haul.
Aug 14, 2011 2:50PM
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Hot As long as both parties continue to buy votes by increasing benefit or tax welfare programs the deficit and debt dilemma will continue to grow. Only by addressing spending cuts and tax reforms will a final solution be found. Their needs to be generous cuts in defense with more spending on alternative energy, entitlement reform to Medicare and Social Security and tax reform to eliminate class deductions, special loop holes for dividends and hedge funds and flatten the rates with everyone paying something even if it's 1%.  

Aug 12, 2011 5:12PM
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MR. Housel,
     Only true followers of one party go around preaching about voting because they seem to think that their candidate has it all figured out and will fix everything. Given the last decade of federal money management, how can you advise anyone to vote with confidence with either party when both sides have been in office and both have failed. IMO, voting hasn't helped anyone in the country in many years.

Aug 11, 2011 5:41PM
avatar

Seems to me that when you vote for American Idol that you get up to 10 votes.

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