Everyone has been talking about the debt ceiling, and many of them know a lot more than me. But here are just some of my thoughts.

The truth is that no one knows what will happen on August 2nd. Although many thought the end of the world would come at the end of the Mayan Calendar on 12/21/2012, it could happen this Tuesday. On the other hand its possible that the consequences will not be as disasterous as many are predicting.

Of course we could get a last minute deal, but this looks increasingly unlikely. This looks more like  Lehman weekend 2.0, where regulators scrambled over the weekend to save the former investment banking giant, but let it collapse instead at the last moment. After Lehman collapsed, the stock market fell ~30% over the next 30 days.

The rating agencies are totally incompetent as evident from their role in the financial crisis. I am not criticizing anyone who works at the agencies, but overall the departments that dealt with CDOs and other esoteric instruments which slapped AAA ratings on completely garbage did not do their due dilligenece. The reason for this is beyond the scope of this article.

Moody’s and S&P have issued threats related to downgrading the US debt rating. With a lingering threat that the US is going to default on its debt obligations, the rating agencies have estimated the chance for a downgrade to be as much as 50% (that was a few days ago, now it seems close to certain). This pressure on part of these rating agencies is triggered by the view that failing to raise the debt limit AND failing come to a large bi-partisan long term deficit reduction package , the US will likely lose its AAA credit rating.

The reason Moody’s and S&P are exerting so much pressure on the US government is also because of the fact that the credibility of the rating agencies was highly questioned after the sub prime mortgage crisis. This is the reason the rating agencies have become more strict and pro-active in their approach towards rating securities.

Under current law, the US national debt cannot exceed $14.3 trillion, it will hit this number on Tuesday August 2nd. In order to service this massive debt, the US government succumbed to two government pension schemes. However, this is only going to last till the beginning of August. With all these circumstances as backdrop, Moody’s has put the Aaa rating of the US bonds under review and put the US government on notice in this regard. It was not just Moody’s that showed concerns over this, but S&P has also warned the US government about the likelihood of a significant downgrade in US credit rating if the government fails to prioritize its debt payments upon failing to up the borrowing limit. The deadline issued for this is till 2nd August.

Even if the default is expected to be low in terms of probability and be short-lived, if it happens, Moody’s is going to assess the future payments in an altered manner and it would no longer be feasible to assign these securities an Aaa rating and it would slip to Aa range.

If the credit rating of the US is reviewed as per the warning of the rating agencies, it is my opinion that outcome will be catastrophic. This will shake not just the US economy, but also the world economy because of the fact that all the economies are so closely integrated with the US, which makes up ~25% of world GDP (~$15 trillion US GDP, ~$60 trillion world GDP). The credit rating are warning about treasuries, which if defaulted, may leave the financial system of the world in chaos.

At present, the treasury securities of the US are considered to be the safest, most reliable and the most liquid of assets in the entire world. They have been considered essentially a risk free asset. It is due to this high level of investor confidence that the US is able to have low interest rates on these securities. However, if the rating gets reviewed, the US will not be able to benefit in this manner. As it has already happened, the yield-to-price rates of bonds issued by the US government have already declined.

If a downgrade in the ratings of the securities occurs, it is going to mean that investors will be more hesitant towards investing in the US treasury securities. As a result of this reduced demand and ownership for the bonds, the interest rates would be forced higher. A hike in the US bond’s interest rates mean that the amount of money the taxpayers will have to pay is going to increase.

 

There is a strong link between the Treasury bond rates and the rates offered on loans and mortgages. An increase in bond rate signals towards a significant increase in the borrowing cost for ordinary people. This applies to car loans, mortgages and also other long-term loans. Higher rates are going to be charged on borrowings and existing rates on mortgages and loans are also likely to be revised upwards. This presents a serious dilemma for the people who will be paying more not only in taxes, but also on borrowed money.

 

However, here lies the more serious risk: A downgrade also presents serious challenge for the money market funds. Considering these funds are supposed to hold 97% of their assets in Aaa rated securities and assets, they will be forced sellers  if the US gets downgraded. This could result in a gigantic forced selling of Government treasuries.

According to the http://www.ici.org:

There are a total of $2.634 trillion held in money market funds. $835 billion is held in US treasuries, 1.558 trillion in corporate high grade bonds/ commercial paper etc., and $302 billion in municipal bonds. Moody’s just placed municipalities, Universities and other agencies in 31 states on alert for a possible downgrade. As mentioned above if treasuries tank so will muni-bonds, which are highly correlated to US treasuries, since most investors purchase munis if they are in a high tax bracket, and munis are  tax free on a Federal and state level (if you are a resident of the state). Additionally, corporate bonds will likely decrease in value as borrowing costs are driven up across all bond classes. Some very stable, short term non-cyclical issuers might be safe, however, it turns out that during the financial crisis of 08-09, even McDonald’s needed a “bailout” from the Federal Reservehttp://www.bloomberg.com/news/2010-12-01/fed-crisis-borrowers-ranged-from-bank-of-america-to-mcdonald-s.html.

Additionally, firms that hold treasuries might have to take write downs if the treasuries collapse in value as a result. The consequences could be serious. Although this looks like a deflationary scenario it could also bring hyper inflation as the dollar becomes worthless since all faith is lost in it.

I do not think there is a single asset class including cash which will be safe if the events I describe unfold. I described this  in a very short article I authored http://www.moneynews.com/Wolinsky/safe-assets-default-investing/2011/07/28/id/405110. However, I did not want to get too much into each asset class right not because I could probably continue for pages as every economy in the world is dependant on the US for trade,