S&P Downgrades US Debt

To top off the worst week in recent memory, the ratings agency Standard & Poor's downgraded the long term United States debt from triple A to AA+. While most US based banks and institutions that hold these bonds have recently renegotiated self-imposed restrictions against holding lower than perfect rated debt in their vaults, the effects this downgrade will have on international institutions is has yet to be determined. But one question remains: why did S&P downgrade T-Bonds, even after the debt ceiling deal?

For weeks now, S&P has been threatening to downgrade US debt if the government did not improve its ability to meet payments. The agency said it would spare the US if the debt ceiling deal included at least $4 trillion in cuts over the next decade. According to the bipartisan Congressional Budget Office, the deal cut less that $2 trillion. Despite a $2 trillion dollar mathematical error that postponed S&P's downgrade announcement Friday, the agency stuck to its guns. Politically, this controversial move was necessary if only to show the public that the agency would make good on its threats. This is especially important when reminded of the role the ratings agencies played leading up to the financial crisis; many highly questionable mortgage backed securities were stamped triple A with little or no due diligence performed.

Despite S&P's claims that politics in Washington threaten the ability of the government to pay its bills, and the historical contextual importance of proving the agency is both comptent and willing to judge financial instruments faithfully, one question remains: what about Fitch and Moody's? How can two of the "big three" ratings agencies believe the US to be triple A worthy and not the third? Judging by their ratings of other nations' debt instruments, it is not accurate to say that S&P is consistently more critical, while the other two are consistently more generous. By and large, the only reasonable explanation I can come up with to account for the lack of consensus amongst the agencies regarding our credit worthiness is the high degree of subjectivity that comes with rating debt. The actual difference between a bond rated triple A and AA+ would be difficult to quantify. Although I cannot prove this theory, it is possible that the complex bureaucratic web that makes up an agency (and the nuanced differences between the makeups of the three agencies) permit different conclusions between them, even if their mathematical models were identical (and we must assume they are not). It will be interesting, if nothing else, to see how the international markets react to this news. All we can do is wait and see.

Debt Ceiling: Is the US Government Still Threatened by a Downgrade?

In an article on thestreet.com, Robert Holmes tells the story of Jeffrey Sica, a money manager, and his politically unpopular view that Standard and Poor, the ratings agency, should make good on its threat to downgrade US paper, despite the debt ceiling deal reached today. This move would be nothing short of necessary for the ratings agency to retain its credibility, especially after a dismal track record of rating dangerous securities triple-A during the pre-recession MBS bubble. This statement resonantes with many Americans still frustrated with the trajectory of federal spending, many noting that no individual or corporation could possibly maintain access to cheap capital with anything close to the spending/revenue ratio we are currently seeing. While S&P has not yet issued a statement regarding this latest debt deal, the markets have reflected the continuing uncertainty felt by many regarding the recent revisions of the first quarter's GDP, and well as recalculations of inflation and manufacturing outputs. Treasury rates are also up, indicating bond investors are not yet willing to embrace "mission accomplished" on the debt problems plaguing the government. Could we be witnessing the decline of modern Keynesian Economics?

EU Sets Terms of Greek Bailout, Bond Holders Take a Hit

Recently, European Union policy makers agreed on the terms for the next round of bailout money to be released to Greece. While much of the plan is formulated around minimizing the moral hazard of yet another large bailout of a sovereign nation, the terms are rather generous (interest rates on the bailout loans have been cut by a third), not to mention placing some of the fiscal responsibility upon private debt holders as well as the country itself.

By far the most debated aspect of the new plan was bond holder participation, so-called private sector involvement (PSI) in the bailout. This complex and somewhat paradoxical scheme intended to save Greece billions by restructuring much of its forthcoming bond debt actually punishes bondholders and EU taxpayers. The problem with the outstanding bond debt is the outrageous interest rates and face-value discounts Greece had to offer to induce investors to purchase the bonds. Now, not surprisingly, Greece cannot afford to pay these rates, and as each payment cycle arrives, the debt total climbs almost exponentially. The solution ---a mercifully favorable solution for Greece --- is what is referred to as debt restructuring. This means that the issuer alters the terms of the loan, or bond in this case, to be more favorable; in this case, cheaper for Greece. This, however, means the bondholders are getting the short end of the stick, about 21 percent less on average than what was stated at the time of purchase. To avoid what could become a riotous situation in the banking community, the debt restructuring program is being offered as "voluntary", as forcing the debt holders to take a hit would be nothing short of criminal. Despite being elective, the EU expects more than 90 percent of all eligible debt will be restructured in one of four offered options: three different swap plans, a rollover option, as well as some buybacks.

Now here's the rub. Except for banks that hold these bonds in their vaults, I cannot see any incentive for the individual investor to participate in these restructuring options (perhaps individuals only account for 10 percent of the outstanding debt held, and was therefore already taken into account, I am not sure). It would clearly behoove a non-institutional bond investor to take at least a small speculative position on Greek bonds when the interest rates were at all-time highs. For that investor, nothing could compel him to take a 21 percent hit unless his only other option was to not get paid at all.

Institutionally on the other hand, this is exactly what banks want to hear. €35 billion is to be used as collateral for the new bonds issued in exchange for the old, to guarantee a triple-A rating. While this does mean the interest rate is substantially lower, it also means banks in Europe are allowed to carry them on their banking books (as opposed to trading books that have more lenient debt quality requirements). For the banks, this is a welcome solution. However, for the taxpayer, this means €35 billion that could be used in other ways (and there are many in Europe today) is doomed to sit in a government vault in Athens to guarantee payout of these new bonds.

While this deal is far from ideal from every perspective, it is a leap in the right direction for a sustainable future in Greece as well as the greater European Union.

Gof6 Budget Plan: Will it Help Raise the Debt Ceiling?

For some reason, the answer appears to be, no. Surprisingly enough, the criticisms regarding the plan drafted by the "Gang of Six" and its inclusion into debt ceiling negotiations came from both sides of the aisle. House republicans have already begun to critique the plan because of inclusion of "tax hikes" in the plan. Senate Democrats have been cited saying the proposal comes too late to be included in the debt ceiling negotiations.

Despite what is being said, it does not appear that any new taxes are included in the proposal. While 26% of the dollar total of the bill comes from "revenue", as I read it, the proposed money comes from closing tax loopholes and streamlining the confusing tax codes. While this will generate up to $1 trillion in revenue over the next ten years, the technical data reveals an actual "$1.5 trillion tax cut".

While this is a leap in the direction of austerity that America desperately needs, the implementation of any plan resembling this one is likely not to be even discussed in Congress until August 3rd (assuming the debt ceiling is raised).

Breaking News: Gang of Six Proposes Budget Plan

http://online.wsj.com/article/SB10001424052702303661904576456042405686316.html?mod=e2fb

Balanced Budget Amendment; Would it Solve...Anything?

Next week the House of Representatives is set to vote on the so-called "Cut, Cap, and Balance" bill, aimed at achieving a viable path towards a more sustainable future. While the intentions of such a plan are indeed admirable, we learn from studying economics that intentions are meaningless; only incentives and results matter in the end. A most interesting aspect of this "Cut, Cap, and Balance" plan is the "Balance", meaning implementing a balanced budget amendment to the Constitution. A recent Sachs/Mason-Dixon poll revealed 65 percent of Americans support a balanced budget amendment. But would requiring the federal government to balance the books solve anything? And what does it mean to balance the budget?

While it sounds simple enough, there are some common misconceptions regarding both balancing a budget and how requiring the government to do so every year could affect the economy. Let us begin with what it means to "balance a budget". To have a balanced budget is to equate revenues with expenditures. In other words, you bring in as much as you put out, or spend. The literal meaning of a balanced budget is to run neither a deficit (to spend more than you bring in during a given year) nor a surplus (to bring in more than you spend). This particular definition is very narrow, implying that every cent is matched exactly a year in advance. Some would concede that running a budget surplus would not be excluded under a balanced budget amendment, however I have no reason to believe, based on my research, that this provision is included in this particular bill.

As counter intuitive as it may be, running a strict budget could actually create an environment that incentivize unnecessary spending. This can be seen in the corporate world all the time. For example, if the R&D department at a particular company ran under budget (producing a budget surplus) for a year, it is very likely that the budget for that department would be cut the next year to reflect the fact that they had been allotted "too much" the previous year. The provides incentives for every department of the company to spend every penny of the budget, whether it is needed or not. It would not be hard to imagine a branch of the government spending their way up to their limit at the end of the fiscal year in order to maintain the maximum available appropriation for the next year.

In addition, many economists prefer to have a degree of elasticity to run a surplus during the "boom times" and a deficit during the "bust times". Requiring every dollar to be accounted for would not allow the government to efficiently reap the benefits of good times or to borrow in times of great need, as we did in the wake of the 2008 recession. Most economists prefer what is referred to as a "cyclically balanced budget", which is to balance a budget not annually but per economic cycle. This, however, can only be interpreted and analyzed in retrospect, after each economic cycle is completed, and would therefore be impossible to regulate.

While a balanced budget amendment may not solve our nation's woes, it is clear to most Americans that something must be done to hold the government accountable for its spending. However, if it was possible to regulate or legislate our way to fiscal responsibility, I am sure we would have implemented it by now.

News Corp: What does Les Hinton have to do with News of the World?

News broke today that Dow Jones CEO Les Hinton resined as part of a damage control campaign in Rupert Murdoch's News Corp empire. While most media outlets did not make much of this, I was perplexed! Why would a largely liked CEO of an American news corporation resign because of a scandal involving a British tabloid? Granted, Dow Jones is held by News Corp just as NotW was, but if the incidents in England were isolated as they have been reported by Murdoch, why is Hinton resigning? Now, I am far from a specialist in the field of corporate formalities, but as an FBI investigation is underway in America, it seems that the resignation of Hinton could be a case of abdicating responsibility. When viewed through the lens of a skeptic, this act looks an awful lot like admission of guilt, rather than polite formality.