Death of the Treasury Benchmark: James Saft Commentary

By | July 26, 2011

A U.S. default or debt downgrade may set off market fireworks but the longer-term effects of the death of Treasury bonds as a universal benchmark of risk may ultimately be more significant.

The U.S. appears to be slouching towards a self-inflicted debt crisis, with Democrats and Republicans unable to agree a plan to lift the $14.3 trillion debt ceiling by the Aug. 2 deadline.

Even if such a deal is agreed, it may not be radical enough to satisfy ratings agencies, notably S&P, which has said it wants to see a $4 trillion reduction over 10 years. A deal on that scale seems unlikely by the deadline, meaning we may be looking at another round of negotiations in 2012, an election year.

All of this may be enough to push S&P or one of its peers into an exemplary downgrade even if there is no technical default, stripping the U.S.’s AAA status and risking an unpredictable chain reaction in global markets.

Even if none of this happens in the next few weeks, the larger truth is that the illusion that the U.S. is a solid-gold credit which can never default is lifting.

That concept — that the U.S. is the best possible sort of borrower, one that can never default — has been at the heart of the global financial system for decades. Investors have believed, mistakenly it turns out, that they can measure risk by comparing all credits to the U.S. Treasury benchmark. This has been an incredibly useful convention, giving financial markets a foundation upon which to build riskier investments, a means to gauge risk and a harbor to flee to when seeking safety.

The Treasury market’s ability to serve all of those functions will diminish over the coming years, not because the U.S. will default — it probably won’t — but because the words “permanent” and “risk-free” have meaning and everyone will now know they cannot be applied to Treasuries.

That’s bad for Treasuries, and will drive the cost up at which the U.S. can borrow, but it may prove to be worse for everybody else. A huge preponderance of all of the decisions and investments made in financial markets rely, directly or indirectly, on the concept of a risk-free rate.

The issue is not simply that the world will extract a higher rate of interest from everyone else because the U.S. is a less good credit, but rather that the process of figuring out who is a good credit and how to calibrate the relative difference of risk between one borrower and another is now infinitely more complex.

And, as complexity in systems is expensive, the overall cost of credit will rise.

RISK MISPRICED, CAPITAL MISALLOCATED

That’s actually probably a good thing, as the illusion of a risk-free U.S. borrower has led to an enormous misallocation of capital globally, from the fighting of wars the U.S. could not afford to the building of marble-clad bathrooms its consumers did not need.

Good it may be in the long term, but good it will not feel as it is happening.

My guess is that actually poorer credits will suffer more than Treasuries in the immediate aftermath of a U.S. credit event. If you no longer know where you are, you will try to take on less risk, like a driver who suddenly finds themselves in an impenetrable fog.

Think, for example, of the largest banks: people have been willing to lend them money based on the assumption that they are backstopped by the government, a AAA risk. The risk of lending to a too-big-to-fail bank does not rise in step with the rise in risk of lending to the government, but far faster.

Eventually, many corporations may be able to borrow more cheaply than the U.S. Already it is cheaper to buy default insurance on some large U.S. corporations than on the U.S. itself. The larger point is that everybody’s cost of credit will rise, because people are discovering that there is far more risk in the system than they imagined, and because the price of discovering that risk is far higher than we all assumed.

There is an irony too in the potential for a ratings agency to deal a key blow to the U.S.’s illusion of credit invulnerability. While some of the work done by ratings agencies was solid and some worse than useless, the fact is that investors before the crisis became far too reliant on ratings, and gave them far too much credence.

As faith in credit ratings ebbs, the cost of credit should rise to reflect the higher costs of actually doing your own analysis.

Shorn of our assumptions, we are all likely to charge each other more to borrow, slowing growth even further.

(Editing by James Dalgleish)

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com.)

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