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S&P Downgrade Doesn't Make Sense

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The S&P downgrade is a unique occurrence in the annals of finance: A storied institution puts its credibility at risk, unnecessarily, to make controversial statement of deep conviction.

While I applaud the principle, I wish the McGraw Hill-owned (NYSE: MHP  ) Standard & Poor's had reserved such chutzpah for a more deserving cause. Here's why.

The U.S. can't default
The basic problem with S&P's decision is that it's not true. A credit grade is supposed to reflect the probability of default, and the probability of our country defaulting on its debt is exactly 0. The U.S. cannot default -- unless we want to, and last week's vote shows we really don't.

You may be asking, "Chris, if we continue to spend beyond our means, won't we eventually have to default?"

No. This is because U.S. bonds are obligations to pay back a fixed quantity of dollars. Therefore we can always print more dollars to meet our obligations. The U.S. can never default unwillingly.

As Warren Buffett told Fox Business News, "Think about it. The U.S., to my knowledge, owes no money in currency other than the U.S. dollar, which it can print at will. "

And Buffett is putting his money where his mouth is: Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) , he announced, will continue to hold more than $40 billion of short-duration T-bills; he said he views them as "quadruple A."

I also doubt Moody's (NYSE: MCO  ) will downgrade after seeing their largest investor's quizzical reaction.

"But Chris, if the U.S. has to print dollars won't that lead to inflation? Isn't that a de facto default?"

Inflation is a separate risk from credit risk. Inflation doesn't just affect Treasuries but all bonds denominated in dollars, including U.S. corporate and municipal bonds. It's a risk priced in independently of credit risk.

If S&P is trying to say that investors in Treasuries are going to get their purchasing power destroyed, that is akin to saying that Treasuries are overpriced. But it's not the job of a credit ratings agency to say whether a bond is correctly priced, only whether the issuer can meet its obligations. And since U.S government obligations are dollar-denominated, we always can.

"OK, Chris, but if we continue to spend like drunken sailors, won't the credit market eventually wake up and refuse to lend?"

Therein lies the fear, that the credit market will see inflation coming and refuse to lend at anything less than usurious rates. This is the sole reason to worry about the deficit.

But right now, investors are seemingly afraid of everything but inflation. The U.S. government can borrow money at 3.8% for 30 years. Evidently, what investors are afraid of is how fragile the economy is, something the S&P downgrade can only make worse.

What to expect
Typically when an issuer has its credit downgraded, its bonds fall in price so that its yields increase, thereby pricing in greater risk.

If I were a betting man, however, I'd say just the opposite will happen in this unusual case.

You see, Treasuries occupy a weird Twilight Zone place in capital markets. They are expected to be the "risk-free asset," or the asset that is less risky (if held to maturity) than any other.

So, paradoxically, the uncertainty generated by S&P's downgrade may fling investors into the arms of the rebuked asset-Treasuries.

I'd watch to see how interest-rate sensitive Treasury ETFs like iShares Barclays 20 Year Treasuries (NYSE: TLT  ) and iShares Barclays 7-10 Year Treasury (NYSE: IEF  ) perform. My bet would be they'll go up in price.

The real fun will be watching how gold and the SPDR Gold Trust (NYSE: GLD  ) perform over the following weeks. My guess would be that gold will go down in price despite its marketing as a "safe-harbor" asset: As gold gets more into the hands of traditional retail investors, its price will follow what most retail investors (unfortunately) do -- sell when things get scary and buy when things aren't.

As for equities, the market could interpret this in three different ways:

1. "Yay, S&P finally got it over with. And we agree that all bonds, including Treasuries, are a pretty bad bet right now with inflation possibly coming down the line, so better buy stocks instead!"

2. "Oh no, Treasuries are going to go down, and therefore stock prices (whose earnings yields are compared to those available on Treasuries) are going to go down, too. Better sell."

Or my personal favorite:

3. "Congress may actually cut spending. Which is bad for employment and bad for stocks. Better sell."

The third case is the most likely if stocks go down but Treasuries go up today.

Regardless of how the market reacts, I think it's important to keep calm and carry on.

If you liked stocks on Friday, you should love them after today.

Fool contributor Chris Baines is a value investor. Follow him on Twitter @askchrisbainesChris's stock picks and pans have outperformed 90% of players on CAPS. Chris owns shares of Berkshire Hathaway. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Read/Post Comments (9) | Recommend This Article (20)

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  • Report this Comment On August 08, 2011, at 4:18 PM, TheMotleyTimbear wrote:

    "The basic problem with S&P's decision is that it's not true. A credit grade is supposed to reflect the probability of default,"

    Credit ratings reflect the probability of default, among other criteria as well. Perhaps inflation/devaluation of the dollar warranted the negative outlook and downgrade, as funds are sucked out of the economy to pay for debt service, economic growth slows, and tax receipts decline. Longer-term holders of public debt won't like to see their interest payments in depreciating dollars

  • Report this Comment On August 08, 2011, at 4:51 PM, majestik wrote:

    This downgrade reflects a considerable probability of sovereign bankruptcy.

  • Report this Comment On August 08, 2011, at 5:15 PM, JeanDavid wrote:

    "No. This is because U.S. bonds are obligations to pay back a fixed quantity of dollars. Therefore we can always print more dollars to meet our obligations. The U.S. can never default unwillingly."

    Printing more dollars IS defaulting. If there are 1000 dollars circulating in the world, and the government borrows an additional 500 dollars, that might be OK. But if they do not raise taxes or sell something, they cannot pay it back unless they print the 500 dollars they owe. But if they do that, there are 1500 dollars circulating, so each one is now worth only 67 cents. If I was the one making the loan, they would have to pay me 1500 dollars to make me whole, but they would not, since that is not how bonds work. So I would have lost $500, and I could not even take that as a capital loss on my income tax.

    Now legally, they have not defaulted, but as a practical matter they have.

  • Report this Comment On August 08, 2011, at 5:51 PM, rfaramir wrote:

    To advocate printing money to pay debts is to advocate the destruction of the currency.

    The US is in complete control of how much US currency exists, but NOT in control of how others regard that currency. The more we print the more holders of dollars hate us. Witness comments by Russian and Chinese leaders.

    The "full faith and credit of the US" is our reputation. One's reputation is a mental image in the minds of other people. It is NOT something we control, but other people change their minds relative to our reputation in reaction to our actions. Printing money damages it because that is an immoral way to deal with debt.

    Cutting our expenditures to match our income is the only moral way to deal with it. Borrowing just forces those who come after us to deal with it, and thus is likewise immoral, since they must either pay more than we would have to, or they must default. (Higher revenues are not a moral answer, since they are an involuntary taking of another's life efforts.)

    Cut spending. Allow freedom to transact in any currency. End the Fed.

  • Report this Comment On August 08, 2011, at 6:10 PM, xetn wrote:

    The U.S. can't default"

    That is what they said about Weimar Germany, Argentina, Zimbabwe and a host of other countries (all the way back to the Roman Empire) who tried to spend beyond their means and debased their currencies.

    Oh, and by the way: gold up $53.80. Why do you think that is? Because we have a "default proof" economy?

    Who was it that said we should all sell last week and who said that was a stupid idea?

  • Report this Comment On August 08, 2011, at 9:47 PM, TheDumbMoney wrote:

    Well, the counter argument is that around 80 members of the House of Representatives were fulling willing to risk default for the sake of a no-tax position. And while they are correct that we would not have defaulted on August 2 because we could still pay bond coupons, we eventually would have defaulted, and they gave every indication that they were fine with that. A number of members of the House of Representatives actually affirmatively stated that they would like for the U.S. to default. While all of your points are true, what happens if 80 more of these people get elected in 2012? It could happen. I would say there is at least a chance of a voted default. Is a country AAA when a significant number of its elected legislators actually want to vote for a default? What would JNJ's S&P rating be if one or two of its board members were running around saying on CNBC that JNJ should just not pay some of its loans, even if it was capable of paying them?!? :-)

    Also, an AA+ rating is hardly S&P saying we will default anyway. No country rated single A or better by S&P has defaulted (at least while it has that rating, though I'm pretty sure S&P only pulled Iceland's rating just in time).

  • Report this Comment On August 09, 2011, at 12:51 PM, JDM62 wrote:
  • Report this Comment On August 09, 2011, at 2:45 PM, lehem wrote:

    Dumberthanafool: Looks like about 95 democrats voted for default. On the whole I would say more democrats are trying to destroy the USA more than republicans.

  • Report this Comment On August 13, 2011, at 1:45 AM, chaz572 wrote:

    lehem, that's bull. Only Republicans came out and said they'd actually like the country to default.

    Democrats voting against a tilted deal was a statement of not caving to hostage takers. The Republican position was to point a gun at the economy and fail to negotiate in good faith. Republicans demanded that they give in on none of their sticking points, while Democrats cave on all of theirs. That's not compromise, and that's not negotiation. That's hostage taking. And when you're claiming you're willing to default over it, that's economic terrorism. Anybody who voted for that is condoning that behavior and asking for more of it. What happened to "We don't cut deals with terrorists"? I guess that doesn't count when the terrorists are on your political side.

    And frankly, the Republicans' behavior in this whole mess is *exactly* why S&P was entirely correct and justified in downgrading. There's nonzero risk of default when a significant block of lawmakers are willing to use intentional default to push their extreme agenda against the will of the majority.

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