Credit-Default Swaps on US Treasuries Have Risen Nearly 40 Percent Since Bailout Law Signed; Now About the Same as on Mexican and Thai Government Debt → Washingtons Blog
Credit-Default Swaps on US Treasuries Have Risen Nearly 40 Percent Since Bailout Law Signed; Now About the Same as on Mexican and Thai Government Debt - Washingtons Blog

Wednesday, October 29, 2008

Credit-Default Swaps on US Treasuries Have Risen Nearly 40 Percent Since Bailout Law Signed; Now About the Same as on Mexican and Thai Government Debt

Bloomberg writes the following bombshell:

"Credit-default swaps on [U.S.] Treasuries have risen nearly 40 percent since TARP was signed into law Oct. 3, and are now about the same as Mexican and Thai government debt before the credit markets began to seize up in June 2007."
The article also states:

"Trading of credit-default swaps on government debt has increased since countries from the U.S. to Germany began pumping cash into their banks to prevent more failures, said Puneet Sharma, head of investment-grade credit strategy at Barclays Capital in London. The expenditures mean the 'probability of downgrade has increased,'' he said.

Investors are buying protection on countries to speculate on a deterioration of their credit quality and ratings as governments take on risky assets, even if they don't think there is a chance of default."

What do "probability of a downgrade" and "deterioration of ... credit quality and ratings" mean?

Well, credit rating agencies, such as Standard & Poor's and Moody's, assign credit ratings to countries, as well as companies.

A September 18 article in Bloomberg raised the possibility of a credit downgrade for the U.S.:

America's credit "profile is now weaker because contingent risks have become actual risks to the U.S. government,'' said John Chambers, managing director of sovereign ratings at Standard & Poor's in New York.

In fact, Standard & Poor's raised a possible downgrade of U.S. credit back in April. An article in Marketwatch explained:

The performance of government-sponsored enterprises like Fannie Mae could have a direct impact on the national economy and more importantly, the credit standing of the U.S., Standard & Poor's said Monday.

Fannie and Freddie, which enjoy implicit government guarantees, could cause the U.S. to lose its sterling triple-A rating if the government were forced to come to their rescue, the ratings agency said in a report.

"Even damage from GSEs is unlikely, the greater risk to the U.S. lies with them than with broker-dealers," S&P noted.

The demise of Bear Stearns Cos. - and the Federal Reserve's extraordinary efforts to alleviate strains at broker dealers - has captured the attention of market participants who feared that the financial system would seize up last month.

S&P, however, noted that while this credit crunch has caused financial markets to swoon, it hasn't threatened the standing of the nation's credit quality upon which U.S. Treasurys and the debt priced off this government debt depend.

But should a protracted recession cause Fannie and Freddie to buckle, S&P said, the U.S. rating would be in danger.

Of course, Fannie and Freddie did buckle and - in many ways - the health of the U.S. economy is much worse than it was in April, and the U.S. is spending literally trillions of dollars it doesn't have on corporate bailouts.

A 2005 article in Lew Rockwell called "Should the US Government’s Sovereign Credit Rating be Downgraded to Junk?" provides some details of how credit rating agencies assign credit ratings to countries:

When examined objectively, one could make the case that Uncle Sam’s sovereign credit rating should be downgraded – perhaps even to "junk." So where are the credit rating agencies? Are they going to miss this one just like Enron?


Both Moody’s Investors and Standard and Poor’s have granted the U.S. the highest sovereign credit rating possible (Aaa and AAA respectively). Most other countries are less fortunate and have lower credit ratings – which can affect such a country’s interest rates and access to the credit markets. The lower the credit rating, it is believed, the higher the chances are for a country to default on its sovereign debt obligations. Be aware S&P downgraded Japan’s sovereign credit rating to AA– on April 15, 2002 . . .
The article then analyzes the U.S. economy using 8 traditional credit-rating factors, and concludes that the U.S. has performed abyssmally in all 8:
Having gone through all eight variables, it should be obvious that both Moody’s and Standard & Poor’s have grossly overrated America’s sovereign debt – it doesn’t merit the top grade of AAA. In variables such as default history, inflation, external balance, external debt, and economic development, the U.S. should rate significantly lower than does Japan – and should rate worse in many variables as compared to a developing country such as Botswana.

So why hasn't America's credit rating been downgraded?

Well, a report by Moody's in September states:

"In superficially similar circumstances, the ratings of Japan and some Scandinavian countries were downgraded in the 1990s.


For reasons that take their roots into the large size and wealth of the economy and, ultimately, the US military power, the US government faces very little liquidity risk — its debt remains a safe heaven. There is a large market for even a significant increase in debt issuance."

So Japan and Scandinavia have wimpy militaries, so they got downgraded. But the U.S. has lots of bombs, so we don't?

In any event, as a quote from the Marketwatch article cited above hints, foreign governments themselves will likely demand a higher interest rate when loaning money to the U.S. because of its precarious situation:

"The federal government assumes that it can borrow whatever it wants from foreign lenders at low interest rates for as long as it wants,'' said David Walker, former comptroller of the U.S. Government Accountability Office who's now head of the Peter G. Peterson Foundation in New York. "That's an imprudent assumption."
Indeed, the International Monetary Fund - which oversees third-world economies - is so concerned about the solvency of the U.S. economy that it is conducting a complete audit of the whole US financial system. The results of that audit might be more honest than credit ratings by American companies, and may result in a reduced opinion of America's creditworthiness.

One way or the other, America's credit rating will be downgraded, which will only add to America's financial problems.

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