When Riskless Gets Risky

July 14th, 2011 at 9:30 am

Moody’s bond rating agency got into the act yesterday and put the US credit rating, which has been Aaa (highest rating) since 1917 on its “downgrade watch.”

No surprise there and markets largely shook it off.  The 10-year Treasury is up a few bps (basis points, or hundredths of a percentage point) to 3.13% but the recent trend confirms that investors continue to believe there will be no default.

Source: Bloomberg

BTW, you’re well within your rights to take a jaundiced view of the bond raters—they didn’t exactly distinguish themselves when they were giving high grades to dangerous mortgage bonds a few years ago.  But I agree with their assessment: “the probability of a default on interest payments [is] low but no longer de minimis.”  More on that in the next post.

But here’s something from the Moody’s release that’s worth keeping in mind.  I’ve stressed that in an economy where publicly held debt amounts to around $10 trillion, even a 50 bps increase in the interest rate adds $50 billion to debt service (and thus to the deficit).  But it’s also worth contemplating all the other rates that are tied to the so-called “riskless rate” of US Treasuries.

“In addition to the financial institutions directly linked to the US government, Moody’s has also placed on review for possible downgrade pre-refunded municipal bonds…, certain housing bonds…, and other municipal ratings that are directly linked to the rating of the US government. Bonds issued by the governments of Israel and Egypt that are guaranteed by the US government were also placed on review for possible downgrade…[also], transactions backed by…government guaranteed student loans, and US RMBS backed by government agency mortgages.”

And that’s probably a short list.  Tons of debt is benchmarked to the heretofore riskless T-bill rates and it will all become more expensive if the probability of default sharply increases.

We’re letting riskless get risky, and that’s not at all smart.

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6 comments in reply to "When Riskless Gets Risky"

  1. rjs says:

    you’re looking at the wrong market; those anticipating a US default will insure near term debt thru credit default swaps…i havent checked lately, but even on june 15th, the cost of CDS to insure US 2 year debt was higher than that of the cost to insure the same for brazil or italy..


  2. Geoff Freedman says:

    Thw politics here are risky beyond imagination.

    If we continue much longer down this path, even if we don’t end up defaulting, interest rates will go up because we will lose confidence and trust beyond our own shores because of the politics envolved right now. This will further limit any intermediate and long term plans for dealing with our debt and budgetary issues. We only have about a week to get this right without there being some long term interest rate consequences in my opinion.

    In addition, I’m sure that businesses will be less reluctant to spend even if some good economic news were presented. In fact what I expect to happen is environment will trigger more economic bad news. No one can tell me that this nonsense will add confidence.

    By the way, I think in this climate, student loans could be the next ‘bubble’.

  3. Robert Thille says:

    Can you (or some other commenter) explain this further: “I’ve stressed that in an economy where publicly held debt amounts to around $10 trillion, even a 50 bps increase in the interest rate adds $50 billion to debt service… ”

    Given that the $10 trillion in debt was previously sold, and the interest rate fixed on the bonds at the time of sale (if I understand T-bills correctly), wouldn’t an increase in the interest rate on T-bills only affect any newly issued bonds? So, unless we are turning over $10T in debt at a high rate, it would take years before an increase in interest rates would take full effect?

    • David S. says:

      Robert asks a good question. Even more important than the rollover of the old debt is the significant loss in value of the existing debt held by private entities, especially banks. Higher interest rates meand a drop in the value of existing Treasury securities.

      And aside from the loss of value — in the hundreds of billions — the capital of banks will be eroded, resulting in their technical insolvency and their need to reduce their loan-to-capital ratios, depressing economic activity.

      And I haven’t even begun to consider how the credit default swap market will handle this issue — because that market is so opaque (thanks to the joint efforts of the Clinton Administration and the Republican in Congress to silence Brooksley Born at the CFTC).

  4. azlib says:

    And the media continues to call the Tea party folks fiscal conservatives? They are anything but fiscal conservatives. Meanwhile Rome continues to burn (high unemployment, anemic economic growth) while we deal with this made up political issue which has the possibility of tanking the entire economy.

    • Chigliakus says:

      If the May and June jobs reports are any indication the economy was tanking fine on its own before this made up political issue came to the fore.