S&P's Decision Triggered Cascading Downgrades

Includes: GOLD, VXX
by: HiddenLevers

By Raj C. Udeshi

The S&P wonks just created a lot more work for themselves. They should have known that once you downgrade the United States, there is a huge to-do list that awaits. If the keystone gets chipped, then you’re going to have to readjust everything that is tied to it too. Tons of credit ratings are subordinate to the rating on US Treasuries.

Some must be downgraded because they have macroeconomic vulnerability to the US government -- they depend on the full faith and not as good credit of the United States -- and others must be downgraded simply because of the sovereign ceiling; no private firm in a particular country can receive a rating higher than that of the sovereign. As seen in 2008 and the 1998 Asia crisis, this sovereign ceiling policy might not be as strictly applied by rating agencies as it used to be.

US banks cannot be higher rated than the country that backs the banking system. European countries are in worse shape than the US on debt-to-GDP ratios, and are unable to print currency. European banks' exposure to Greece and Italy bond defaults also cannot be higher rated than the country that backs the banking system).

Regarding municipal bonds, they are pre-funded with escrowed Treasury bonds; backed by federal leases; used for areas with high concentrations of Department of Defense operations and for states and local governments that depend on federal spending, as well as for agricultural entities (although government farming subsidies are at all-time low).

Also worth considering are Fannie and Freddie (fully guaranteed by the US Treasury and already downgraded); Israeli sovereign debt; mortgage REITS (mortgages backed by Fannie and Freddie, and leverage decreases, so not as much profit); and insurance companies that may hold US Treasuries and municipal bonds that are closely linked to Federal debt: Northwestern Mutual, Teachers Assurance & Annuity, USAA already downgraded.

On a macro level, here is what the cascading downgrades scenario looks like. I used the HiddenLevers scenario hedging screener to discover some safe harbors. Here are two:



Expected Performance

1Y Return

iPath S&P 500 VIX Short-Term Futures




Randgold Resource Limited




Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.