When the idiots in Washington dared to play political games with the debt ceiling issue,they dared to tempt fate and inadvertently opened Pandora's Box.They had been repeatedly warned by the rating agencies, particularly S&P, that a downgrade was likely. The idioits thought they were bluffing and wouldn't dare and then attempted to turn the screws on them. Two of them, Moody's and Fitch both fell in line, but S&P didn't and called their bluff. Each side of the debt ceiling 'debate' White House, Dems and Republicans, intended to gain political points in a two week display of incredible stupidity. What they ended up inadvertently achieving was to put on display the sordid condition of US finances and politics for the whole world to see. Thursday's rout in the markets was but one reaction, of which there will be more. That event will undoubtedly go down in history as a Nero fiddling while Rome burns event. I believe that S&P went ahead with the downgrade for two reasons. One, they were honestly attempting to restore their badly tarnished reputation and two, they are scared, that they reviewed the US accounts in detail and were horrified at what they saw. I believe that S&P did the honorable thing both before and after the debate so let's give some credit where credit is due in a rare display of courage. The White House attempted to use the S&P warnings to score points against the Republicans when Obama claimed that a down grade would destroy Christmas by causing credit card interest to rise. Just one more display of the putrescence that has descended on Washington. Then they did an about face and tried to spin it as no big deal as most of the media did and will continue to do. But they are wrong. It is a very big deal.
The main effect of the down grade is to once again put the world on notice that the US debt is not only unsustainable, but also unpayable. It will have a major effect on the shadow banking system and money markets and very likely a fatal effect of causing liquidity to dry up. Recall the start of the financial crisis of 2008. It was all about liquidity drying up. So what does that mean? The US economy no longer operates on money, rather it operates on credit. The actual money supply of the US and all other major nations is but a small fraction of total daily credit transactions. We get a better idea of this when we realize that most major corporations do not have enough cash to make their bi weekly payrolls and have to go into the money markets to get the cash. Corporations keep as little cash on hand as possible, instead preferring to lend ever dollar of unused cash. The lending and borrowing of money by any one corporation is a daily, even hourly event.It is 'just in time delivery' applied to money as well as product. This constant cash shortage and need for cash via borrowing puts them all at extreme risk of a meltdown should anything interfere with the regular workings of the shadow banking system that functions via the money markets.
This is what happened in 2008. When company A borrows cash from company B it does so by putting up collateral consisting most often of US debt instruments but that can be other types of bonds as well. The collateral value of a US Treasury is par value assumed at a rating of AAA. Collateral value is determined by its rating. So what happens when a bonds are downgraded is pretty obvious. They undergo what is known as a 'haircut' which means that its collateral value is reduced. In this case that is likely to be 10%, so now for every $1,000 bond in collateral required of a borrower, he will now have to put up $1100 worth. That has the same effect as an increase in interest rate by raising the cost of borrowing. The cost of borrowing puts a squeeze on profit margins and therefore stock prices. This will have a deadly effect on stock markets because it will reduce leverage.
Yet there is an even greater effect which is to place severe strain on the money markets, the supply of which just got reduced by 10%, money markets that are already under great stress. The bottom line here is that the downgrade could very well trigger another financial system meltdown. The financial tricksters can spin this all they want, but the fact is that they cannot escape from the fact that they just made a bad situation much worse, and very likely fatally so.
Remember also by law many institutional funds can ONLY hold AAA bonds. Nothing less. so by law they would be forced to correct their portfolio.
Expect Monday on Wall Street morning to dawn in a state of sheer panic and pandemonium. Though I doubt Barrack Obama really believed this, the downgrade probably will destroy Christmas, but he caused it. I think the fact that the other two rating agencies, Moody's and Fitch, did not downgrade might take some of the heat off of the bond market. Had it been a downgrade by all three of these majors, the impact would likely be much more severe.
I would expect the immediate reaction to the news in Asian trade on Monday with US Treasury markets opening lower and gold and silver opening higher. JMHO. Regards, Al.
