Josh Dowlut's  Instablog

There’s a difference between nominal default and real default, and the ratings agencies only measure the probability of nominal default.  The U.S. may very well be on course to default on its debt obligations in real terms through inflation and currency debasement.  However, there is no chance of defaulting in nominal terms, because the only requirement is to repay in a currency the government can always print more of.  Could you ever lose at Monopoly if you could write your own money?  It would make for an interesting experiment to see how the other players would adjust their strategies though.

The S&P downgrade also completely ignored the concept of relative risk, which is really the only kind that matters for investing.  The absolute risk of U.S. Treasuries, even in real terms, is unimportant.  It is only their risk relative to other fixed income investment options that matters.  Consider the handful of U.S. corporations that S&P still rates at AAA, are they really a lower risk than U.S. Treasuries which S&P now rates at AA+?  Is it really a safer bet to loan Microsoft money than to loan the U.S. government money?  No, not in nominal terms, or even in real terms.  In nominal terms, the government can print money, MS cannot.  But even in real terms, since MS’ obligation is to repay you in dollars, the exact same inflation risk that applies to government debt, also applies to MS debt.  Every U.S. corporate bond is denominated in dollars.  Every U.S. state or local municipal bond is denominated in dollars.  Any risk of real default on U.S. Treasuries through inflation applies to every single bond issued in this country.  In terms of relative risk, there is no change, and U.S. Treasuries remain the risk free investment in relative terms.

The irony of the entire situation is that the U.S. government empowered the ratings agencies far more than any competitive market would have ever allowed.  They are probably the best example of a government-made monopoly.  As early as just after the Great Depression, and after the recommendation of the Federal Reserve, bank regulators began using ratings agencies to determine capital requirements, and insurance regulators began using them to determine which bonds were legal to hold.  In 1973, the 5 ratings agencies in existence were given formal cartel/permanent oligopoly status by the SEC.  A rule change required investment banks dealing in securities to hold a higher level of reserves, unless they were dealing in rated securities.  The caveat was that the rating had to come from one of the 5 (since consolidated to 3) ratings agencies.  The ratings agencies have huge profit margins, 52% for the only one that has the publicly traded data, while providing a product that is of laughing stock quality. 

Investors showed they will not heed the “warning” of the ratings agencies as they still treated Treasuries as a safe haven, moving enough money into them to cause interest rates on government debt to plummet, the exact opposite of what would have happened had they actually believed the government carried more risk. 

If Moody’s and Fitch also downgrade, things could get interesting.  Most of the big sources of investable wealth in this world (insurance companies, pension funds, sovereign wealth funds) are barred from holding anything but AAA rated securities.  A downgrade from the other two agencies would lead to an epic scale dumping of government debt under current rules (emphasis on the current rules part).