What difference does it make whether US Treasury debt is AAA rated or AA? The greatest danger is that a downgrade damages consumer and business confidence in the US. Recall that in the Lehman Brothers collapse of late 2008 the biggest problem ultimately was that consumer and business confidence fell off a cliff after 15 September 2008. US consumer confidence went to the lowest levels since accurate records began in the 1950s. The resultant fall in consumer spending and business investment turned a financial crisis pre-Lehman into the Great Recession post Lehman. That is the biggest problem with this debt crisis — it could trash consumer confidence in the US and elsewhere and send the fragile recovery in the US into full reverse.
Most households have got no idea what the issues are in the US debt crisis or a sense of the scale of the problem. When it is reported that gross debt of the US Government is now about 100% of GDP or that the budget deficit is $1.25 trillion this year, it is hard for most people to interpret those figures, so the problem seems somehow distant to them and just so much more noise from Washington. But a downgrade from AAA to AA sounds so dramatic. It is a statement that the US Government is no longer gold plate, no longer bullet proof. It shakes the rock on which confidence rests — faith in the permanence and destiny of the Republic.
If consumer and business confidence was not at risk, then a downgrade would not be such a big deal. So, Moody’s and S&P have lowered their opinion of the credit worthiness of the US Government — big deal. Plenty of pundits are telling us that it does matter, without explaining why. For instance, this morning on the ABC’s AM radio program we were told that if the US loses its AAA rating then interest payments on US debt will rise by up to $100 billion per year. Let’s think about that. $100 billion on $14 trillion of debt is about 0.7% (70 bps). The contention here is that if the US is downgraded then the USD yield curve will jump up by 70 bps. That seems completely implausible.
Why would the yields (interest rates) on US Treasury securities rise at all if the US was downgraded? After all, those ratings are just the opinions of the ratings agencies. If we were talking about some corporation or bank that the market doesn’t pay much attention to, then a downgrade would certainly change the market’s thinking on that corporation and shift the yield on that debt upwards. But we are talking about the US Government here. The markets do not rely on the ratings agencies to form an opinion about the credit worthiness of the US Government.
It is supply and demand for US treasury securities that determines the yield on US Government debt, not the adding or subtracting of a single ‘A’. The supply of Treasuries expands only slowly through time. So, a big jump in yields would require a big fall in demand for US treasuries. Why would that happen? It is quite possible that the opposite would happen. If the debt stand-off in the US causes a global financial panic, then the flight to quality will be into US treasuries sending demand for those securities up and their yields down. That is not just a theoretical possibility — that is the mostly likely outcome if financial crisis arises. No matter what Moody’s and S&P think, US Government debt will remain the risk free asset for $US investors.
Putting aside crisis considerations, what else might cause a drop in demand for US treasuries? First, there are capital adequacy issues. Banks, insurance firms and others have to hold an amount of shareholder capital that reflects the risk that they have absorbed onto their balance sheets. Some banks may have to hold more capital against their US debt holdings; making the holding of US treasuries more expensive and therefore inclining them to sell the securities. However, most banks won’t be affected because US treasury debt will continue to have a risk weighting of zero, even if it is not AAA. Capital adequacy rules for insurance companies are different and some insurance companies will partially sell down their US treasury holdings.
Second, there will be an issue with the use of US treasuries as collateral. Treasuries are used as collateral in the repo market, in the risk markets (options, futures, etc.) and elsewhere. For instance, if a bank was short of cash for a day it might uses some of its holding of treasury assets to borrow overnight cash in the repo market. In this transaction $1.00 of Treasuries can be used as collateral on borrowing of $0.99 of cash. We would say that the ‘haircut’ on the collateral is 1%. If US debt is downgraded then the haircut applied to treasuries might rise to 2% or more, in which case $1.00 of Treasuries will only support $0.98 of borrowing. That would reduce the size of positions that can be taken in the repo market and in the risk markets, and other markets. If many parties are forced to unwind positions simultaneously by selling assets, then a ‘fire sale’ of assets can arise.
It is hard to know how big these effects are. In some ways this ensuing crisis has the feel of Y2K about it. We don’t know whether the passing of August 2 and a US rating downgrade be a bang or a whimper? I think it will be a bang — not because of the effects on financial markets, but because of the effect on US consumer confidence.