Why the Market Doesn't Care About the Debt Ceiling - So Far

by: Leigh Drogen

This is not TARP vote part deux. This is not the same problem. TARP was a response to an asset price problem. The government stepped in to literally create a market again for many securities that were being valued at next to nothing, because something is only worth what you can sell it for today. The 2008 financial disaster was a market problem.

This debt ceiling issue is a political problem that may or may not turn into a market problem because of the fact that our politicians would rather score political points than solve the problems we hired them to fix. The market understands that this is a political problem first and foremost, and because of that we have not seen rising interest rates or a major sell off in risk assets.

Politicians are now out to blame the credit ratings agencies for putting the gears in motion to create a market problem. I don’t want to hear any of it - the politicians had their chance to crush these firms like the useless pieces of crap they are, they serve zero purpose. Yet the Republicans primarily stood in the way of major financial reform. So as much as I blame both parties for the mess that we find ourselves in fiscally, I put blame for not crushing the ratings agencies squarely on the Republicans’ shoulders.

But what will really happen if US debt gets downgraded? Well you have to look at why credit ratings matter in the first place. Asset management firms of all types and sizes have rules as to how much of what debt they can hold according to their charters. Some funds can only hold AAA rated debt, some funds have to hold a certain amount, some don’t have to hold any at all and can do whatever they want. But for the most part, the rules as to what debt they can hold are based on the credit rating firms.

Now take a step back and just bask in the glorious stupidity of this system. Asset management firms abdicate a large portion of their risk management to credit rating firms that have zero fiduciary responsibility to see that they make good decisions. Not only do they abdicate this responsibility, they are often held hostage by it. So in essence, the credit agencies can move markets by downgrading or upgrading an asset, taking the decision making out of the asset manager’s hands, forcing them to sell a security. Where on earth does this perverted system exist besides in the credit markets?

If all of the firms that hold US treasury bonds as AAA securities are forced to sell because of the fact that they are no longer AAA, we will have a monumental disaster of epic proportions on our hands. We will have a market problem.

But will this really take place? Will firms really be forced to dump their treasuries? I think the market is telling you the answer, and it’s a resounding NO.

Pension fund regulators aren’t going to wake up the next day and scream at their asset managers for not dumping treasuries if Moody’s downgrades US debt, it just won’t happen. So I expect that the downgrade is largely ignored, and life goes on.

Now, the bigger question is, will our politicians actually make headway at solving the fiscal problem before us. I see four scenarios here with different market reactions.

One, the idiots in Washington can’t come to an agreement but are scared enough of what could happen to pass a short term bill that kicks the can down the road. This will lead to equity market weakness but most likely doesn’t move treasuries much in the short term as the market will wait to see if a bigger bill can get passed in 6 months.

Two, the idiots in Washington pass a compromise bill that gets us beyond the 2012 elections, but is less than $3B in cuts, and those cuts are probably mostly fake anyway not amounting to any real savings or resolution of our burgeoning deficit or debt. The equity market will treat this well, but the bond market will not. I believe we will see rates slowly rise as the market realizes that Washington is just not serious in any way about solving the underlying issues of out of control entitlement spending, not enough revenue, and not enough investment in the areas of the economy that we need.

Three, the idiots in Washington somehow get together long enough to make a real deal, over $4B in cuts with significant new revenue and investment, a cleanup of the tax code, and maybe a public drowning of a few house members from both parties in the reflecting pool as fair warning to the rest of them. The bond market will take this very well, the equity market I’m not sure of, but longer term it will signal to everyone that maybe we can solve our issues.

And four, we get nothing. This is for me not the scariest scenario. I think we’ll have a lot of volatility in the markets, but it isn’t a death sentence in any way. A delay on a deal may signal to the markets that our politicians are working on a bigger fix than just kicking the can down the road, and I believe they will give them the benefit of the doubt. There will be no immediate disaster if we default. A month, two months, three months later, that could be a major issue. A week or two, no. Asset managers will say screw you to the credit rating agencies, which may turn out to be the beginning of the end for them, hopefully, and we will go on with our lives.

Both sides are using some arbitrary date of default as a scare tactic, don’t let them. The bond market does not have a leverage problem as it did with mortgages in ’08. There will be no mass purge of US treasuries. The more important thing for the market is that they get a real deal done that solves the long-term issues, or we will see slowly rising rates until we do get a real panic brought about purely by price action. Thus far the market doesn’t care.