Most large money managers are operating under the assumption that if the U.S. has its sovereign debt rating cut below triple-A, the impact will be manageable because, in all likelihood, the rating would fall just a notch lower to the double-A range.
But what would happen if the rating agencies decided the situation in Washington is so chaotic and the amount of debt building on the nation’s balance sheet is so enormous that the rating must be cut further, to, say, a single-A?
That’s not a scenario the nation’s large money managers are preparing for, but maybe they should if the budget impasse in Washington continues. Neither President Obama nor the House Republicans are finding common ground on a deficit reduction plan that would clear the way for lawmakers to raise the debt ceiling so the Treasury Department can make good on all the country’s obligations.
So far, the nation’s big ratings firm -- Moody’s and Standard & Poor’s -- have been cryptic about what a downgrade would look like even as they have warned that one might be in the cards from triple-A to double-A if the budget impasse persists.
That doesn’t mean a lower rating isn’t a possibility, however unlikely Wall Street and big money management firms believe it to be. For example, if the country would miss an interest payment on its debt, as President Obama and Treasury Secretary Geithner have said is a possibility if the debt cap isn’t raised, the rating would go far lower than double-A.
“If the U.S. did default,” a spokesman for Standard & Poor’s said, “the rating would be lowered to either “D” (default) or “SD” (selective default –which would indicate that some debt is in default, but not all).
And those lower ratings would pose huge problems for large money management firms, which according to sources, have been focused on what they think is moderate market turmoil that will occur from a downgrade to Double-A. “It won’t be pretty but it won’t be apocalyptic either,” said one Wall Street executive at a bank making contingency plans for a downgrade to Double-A.
Executives at the big money management firms declined to provide specific details on how they are preparing for a downgrade but the general consensus is that the firms are bracing for possible forced sales of bonds that might be sparked by a single notch downgrade.
The problem, this executive and others concede, is if the raters try something bold and downgrade to some lower rating, the market reaction will likely be less predictable. “No one I know is thinking about a downgrade below double-A,” said the CEO of a large money management firm. “If that were to occur, it will take the market by surprise.”
And surprise is something trader and investors can do without. Certainly a default would be cataclysmic; interest rates would skyrocket and corporations would have a hard time issuing debt if the bond considered the safest in the world defaulted. But a downgrade to double-A wouldn’t be so good, either, because most funds are required to hold a certain amount of money in triple-A rated debt, and a certain amount in double-A rated debt and so on.
If the government falls to double-A, it crowds out other securities because these funds would opt to keep the safest lower-rated bonds, according to Larry McDonald, at the McDonald Advisory Group.
The problem is the lower the rating goes, the more market volatility is likely to occur because the funds would have to unload increasingly risky debt into an uncertain market.
And this uncertainty doesn’t just involve mass selling of bonds. It also involves the re-pricing of bond deals, and other complex fixed-income securities such as interest rate swaps and derivatives because many of these securities are priced off of a triple-A-rated US Treasury bond.
These securities would have to be re-priced to reflect the change in the Treasury bond rating; the lower the bond rating, the greater the re-pricing would be as would be the losses that would occur, traders say.
For now, of course, the rating agencies haven’t downgraded the US’s bond rating, and in the end might not if the president and Congressional Republicans come up with a deal that cuts some $4 trillion from the budget and the debt ceiling is raised.
But with the two sides still fighting over the details of a deal, most money managers believe a downgrade is likely. The biggest question is how low will the bond raters go.
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