4 Things to Remember About the Credit Downgrade

Five days, a stock market plunge, and a flurry of finger-pointing later, we're still trying to figure out what Standard & Poor's downgrade of U.S. Treasuries really means. Here are four points I'd keep in mind.

1. It had no impact on Treasuries.
The biggest risk of a Treasury downgrade was the possibility that interest rates would rise. That could add trillions to future federal borrowing costs and stifle economic growth.

But interest rates didn't rise at all after the downgrade. In fact, they've plunged. Monday turned out to be the eighth best day for 10-year Treasuries in modern history. The biggest irony of downgrading Treasuries is that it instantly increased global demand for ... Treasuries. One blogger, mocking the stereotypical investor, quipped: "Treasuries were downgraded? Wow! Sell my entire stock portfolio and get me into Treasuries!"

How do you explain that? It's simple. The risk that led to the downgrade was political. But financially, Treasuries are still the safest, most liquid assets in the world. And the U.S. still has the means to pay its bills. That isn't a question. Investors still flock to Treasuries whenever there's a panic. It's where they feel safe. Incredibly, the Treasury can borrow money for 10 years today at less than half the interest rate offered a decade ago, when the government ran surpluses.

2. It will have no impact on banks.
Banks are required to hold minimum levels of buffer (capital) against certain assets. Risky assets require big buffers, less risky assets require smaller buffers, and Treasuries require basically no buffer at all, since they're considered risk-free.

That could have changed after the downgrade. Without a pristine credit rating, the rules regarding how much capital banks have to hold against Treasuries could have been rewritten, forcing them to scramble to raise more capital. This could have been gut-wrenching, since Bank of America (NYSE: BAC  ) , Wells Fargo (NYSE: WFC  ) , Citigroup (NYSE: C  ) , Goldman Sachs (NYSE: GS  ) , and JPMorgan Chase (NYSE: JPM  ) collectively own almost $1 trillion worth of government securities.

But within minutes of the downgrade, the Federal Reserve issued a statement making it clear: The downgrade will not change how much capital banks are required to hold against Treasuries. This was an incredibly important development that went largely unnoticed. Anything different could have sparked a banking panic. Be thankful for it.

3. The rating agencies' credibility is dubious.
S&P downgraded the nation's credit due to political bickering. That political bickering is mostly about the massive accumulation of debt in recent years. And why has debt exploded in recent years? Because of the financial crisis. And who caused the financial crisis? If you had to come up with five broad culprits, the rating agencies would be one of them. We could not have had a housing bubble like we had without the rating agencies. And we wouldn't have today's deficits without a housing bubble.

Think of it that way, and S&P effectively downgraded itself.

Now, mentioning S&P's housing-bubble fumbles when criticizing the recent downgrade is misleading. While they work under the same roof, the analysts who rate housing bonds are not the same analysts who rate sovereign debt.

But there's another valid criticism beyond S&P's past performance. As I wrote on Monday, S&P's original downgrade report had a glaring math error. When that error was corrected, the nation should have, by S&P's original standards, been in the clear for a stable credit rating. Instead, the revised report changed the benchmarks so that forecasted deficits still fell into a danger zone.

The snafu underscores an important point: S&P's downgrade is the opinion of one very fallible group of people. It's outrageous to think that it should shift the path of the global economy.

4. If there's anyone to blame, it's us.
S&P made it clear: the credit downgrade was mostly a demotion of our political system. Our deficits are large, but our political infighting is massive.

Motley Fool co-founder David Gardner asked an important question yesterday. Paraphrasing a famous Warren Buffett quote, he asked: "Would you be willing to put every last dollar you have into the hands of this particular public official to manage on behalf of our future?"

David didn't mean it literally. But "we stand a far greater chance of improving, rather than further undermining, our creditworthiness as a nation if we as its citizens begin to ask this Buffett question of ourselves prior to casting votes," he wrote.

I think you can take it a step further. A recent poll shows that just 14% of Americans approve of Congress' performance. Another showed most Americans would vote out every member of Congress, regardless of party, if they had the chance.

The amazing thing about that statistic: They do have the chance. They can vote.

Yet so many choose not to. In last year's elections, just 37.8% of the voting-age population made it to the polls. Thirty million more votes were cast for last season's American Idol than for last year's Congressional election.

Think about that. The majority of those who disapprove of Congress' performance don't even bother to vote. These people have very little right to complain, in my view. 

If you're sick of what's been going on lately, and appalled about the debt downgrade and its impact on your investments, do something about it. Vote.

Fool contributor Morgan Housel owns Bank of America preferred. Follow him on Twitter @TMFHousel. The Motley Fool owns shares of JPMorgan Chase. The Fool owns shares of and has opened a short position on Bank of America. The Fool owns shares of and has created a ratio put spread position on Wells Fargo. Try any of our Foolish newsletter services free for 30 days. 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 (10)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 10, 2011, at 12:09 PM, jimmy4040 wrote:

    "The biggest risk of a Treasury downgrade was the possibility that interest rates would rise. That could add trillions to future federal borrowing costs and stifled economic growth"

    In a word, no. That was never a possibility. The real risk which continues is the ripple effect of other down grades such as state and munis, Fannie and Freddie.

  • Report this Comment On August 10, 2011, at 12:27 PM, TMFHousel wrote:

    ^ And the possibility that said downgrades will push up interest rates. A downgrade without any impact on prices is merely an opinion.

  • Report this Comment On August 10, 2011, at 12:37 PM, taralbharatia wrote:

    I don't blame people who do not vote. Whom they gonna vote?. Basically the politicians are all the same for their short term goals and getting re-elected. Take for instance, people were tired of Republican party at the White House for 8 years and than elected Democratic President. Does it changed anything? Next election other party will come to power for another 4 years and same old politics all over again. In all these is the main street who suffer every time no matter they vote or not. May be i am thinking for running for election. At least i will have some job security for a while.

  • Report this Comment On August 10, 2011, at 2:26 PM, jimmy4040 wrote:

    Morgan:

    Current Treasuty yields are unsustainable in a non-recessionary economy with an intact euro. So yes, interest rates will go up unrelated to the downgrades, if you thinkg we're not falling off a cliff.

  • Report this Comment On August 10, 2011, at 7:35 PM, xetn wrote:

    I believe you omitted one thing about the credit downgrade; it wasn't enough. But as Alan Greenspan said on tv recently, "we (the Fed) can just print as much money as they need to pay interest, etc. But that "monetary inflation" is a kind of default in itself because it continues to reduce the value of the money. As a measure, about 1

  • Report this Comment On August 10, 2011, at 7:36 PM, xetn wrote:

    year ago, the Swiss Franc was roughly parr with the USD. Now, it has gained to the point that it takes almost $1.40 to buy one CHF.

  • Report this Comment On August 10, 2011, at 10:39 PM, jimmy4040 wrote:

    Greenspan should know. He printed more of it than everybody else in US history combined until 2008 happened. He is the biggest fraud in the history of the Federal Reserve

  • Report this Comment On August 10, 2011, at 10:59 PM, ershler wrote:

    taralbharatia,

    In the vast majority of elections voters are the final decision makers. If they (the entire voting eligible population of the USA) do not have the required skill sets, or don't care enough, to elect a decent government it seems the problem resides only with them.

  • Report this Comment On August 12, 2011, at 4:54 AM, thidmark wrote:

    Everybody complains about Congress, yet we keep putting the same stupid, corrupt people in office. Doesn't speak well for the citizenry.

    We're getting the government we deserve.

Add your comment.

DocumentId: 1536914, ~/Articles/ArticleHandler.aspx, 4/20/2014 6:28:40 PM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...

TREND TRACKER: Get Rich When the Web Goes Dark

It's time to say "goodbye" to your Internet! One bleeding-edge technology is about to put the World Wide Web to bed. And if you act right away, it could make you wildly rich. Experts are calling it the single largest business opportunity in the history of capitalism… The Economist is calling it "transformative"... but you'll probably just call it "how I made my millions." Big money is already on the move. Don't be too late to the party – find out the 1 stock to own when the Web goes dark.


Advertisement