Three Things You Need to Know About the U.S. Credit Downgrade

The Downgrade of the U.S. credit is legitimate and here's why:

People complain that the ratings agencies have no credibility because of their horrific errors with Mortgage Backed Securities. But two wrongs don’t make a right. Just because the Mortgage department of a ratings agency did something wrong does not mean that the agencies’ work on corporate or government debt is wrong. Further, a new law in 2010 has removed immunity of ratings agencies that used to protect the agencies from lawsuits, so now their work should be more reliable. Their work with corporate bonds (not mortgage securities), except for the Enron and Worldcom frauds, has been acceptable.

So the downgrade from AAA to AA is still legitimate. It should be viewed as analogous to a medical patient discovering a symptom of an illness thus helping motivate the patient to realize he needs to request a painful course of treatment instead of allowing the patient to continue to live in a fantasy where he willfully ignores symptoms of a dangerous illness.

However the rating of U.S. Treasuries is a meaningless academic exercise because ratings do not cover the risk of devaluation or inflation; they merely cover the risk of non-payment. The U.S. Treasury issues debt in U.S. currency. If the debt can’t be repaid, the Fed will simply monetize the debt, thus making it easy to repay. So the U.S. can never default (in the contractual sense), but it could default in a moral sense of paying debts with devalued US. Dollars.

The ratings agencies should simply say “Regarding sovereign debt payable in the issuer’s currency, we don’t rate them because they will never be unable to pay their debts because they can simply have their Central Bank print money (by electronic book entry) to pay the debt when it matures. We don’t rate based on risk of currency devaluation or inflation.”

The real risk from the downgrade is that the equity bubble will pop

People wonder how will the ratings agency downgrade of Treasuries affect their 401K? The stock market is overvalued so the risk of the Treasury downgrade is that investors will awake from their blissful sleep and realize how fragile the financial system is. Then they will react by reducing risk and selling off equities and buying bonds, including buying Treasuries. So the ironic result of a Treasury downgrade is that Treasuries goes up in value!!!

About the author

Don Martin, CFP®

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