by Brian Brady
Commercial Real Estate Finance Expert
Structured Debt and Equity
Licensed Real Estate Broker in AL, CA, and FL
The dictated debt limit deadline looms and a credit rating downgrade, to US Treasury securities and agency mortgage-backed securities, seems likely. Naturally, a spike in treasury yields is expected and a subsequent rise in mortgage rates should follow. That’s right out of the senior year textbook, in most American business schools.
I’m not so sure the fixed-income markets will follow the textbook. Mortgage rates might … do nothing in response the the credit rating downgrade. Here’s why:
The credit ratings agencies lack……well…credibility.
The independent credit ratings agencies ( Moodys, Standard & Poors, Fitch, etc) have a reputation for being late on the scene. They got hoodwinked with Enron, MCI/Worldcom, and Greece. They were asleep at the wheel during the mortgage meltdown, issuing AAA ratings to CDOs, up until late 2007. They are often considered to be too chummy with the issuers (the issuers pay their fee) and when the issuer is a government (with the power to regulate their business), they generally walk on eggshells.
The news may be baked into the market already.
The ratings agencies have been signaling a potential downgrade for months. Clearly, raising the US debt limit will allow the Treasury to remain “liquid” but the agencies have said a downgrade is likely unless a substantive plan is enacted to reduce spending. Cut, Cap & Balance, the “most extreme” of the proposals offered, still might not have been “extreme” enough to avoid a downgrade. Both political parties are demonstrating that they lack the political will to address the long-term structural deficits, needed to bolster the Federal budget, to avoid the ratings downgrade. Fixed income traders seem to be shrugging that off.
US Treasury securities are still considered to be the safest investment in the world.
Certainly there are better run countries than the US but their debt offerings lack SIZE; there ain’t enough of that debt for the real money. Germany has its EU obligations hanging around in the background and Japan seems to be in worse shape than we are. Chinese sovereign debt could be a consideration but the Chinese and Japanese still want their investments dollar-denominated. The US is, for all purposes is “too big to fail”. While a world-wide bailout, under the auspices of the IMF seems unlikely, a de facto bailout, by countries who have no other place to park their cash, will probably happen. As paradoxical as it might sound, the ratings downgrade might attract more money because it affirms that while the US is getting ugly, we’re still the prettiest girl at this dance.
Domestic institutional investors are married to the US Treasury.
Insurance companies, state pension funds, union pension funds, banks, and credit unions are bound by charter to invest a certain amount of assets in US Treasury securities or agency derivatives. Banks are amending their charters to read that they “must invest in AAA securities or government debt” this week, to facilitate the downgrade. If you can’t be, with the one you love, baby, love the one your with.
Rebalanced portfolios could attract more money to US Treasuries
A downgrade will most likely affect the credit markets through the overnight borrowing market (where short-term treasuries are used as collateral). This could hamper the availability of private sector lending a bit which could be detrimental for domestic equity markets and corporate fixed income issuers. Subsequently, portfolio managers might rebalance their portfolios by trimming back on stocks and corporate bonds, and seek a “safe haven” with the proceeds. That safe haven may be the very asset class which caused the mess. Go figure.
The Fed might just continue to be…The Fed.
I’ve given up on trying to figure this creature out. The Fed does crap I never knew it could do (well, because it never could do what it’s done these past few years). The Fed could announce QE17 and start bidding 102 for the new treasury auctions, with the sole intent of “fooling” other investors into thinking the issue is in high demand. Please don’t tell me I’m a conspiracy theorist; the Fed has transparently operated outside of its charter for AT LEAST 3-4 years now.
Another thought is that the spread between mortgage-backed securities and treasuries could narrow after a downgrade. The bad news buried in the back of the breadbox is tempered by the fact that the MBS market has a sugar daddy rich Uncle Fred and Aunt Fannie, which continue to be wealth redistribution conduits. Traders might figure that the profitable loans stay in the MBS pools while losses are laid off on the Treasury. If this theory gets traction, mortgage rates could be flat or actually go down.
None of this makes any sense but, in the world of “too big to fail” it ain’t supposed to make sense…it’s just the “right thing to do”. Right?
Call me Alfred E Neumann but I’m not too worried.
Sean Purcell says:
Fun article; it’s always nice to stretch the imagination and play games with reality, though I think Pollyanna might be more appropriate than Alfred E Neumann.
The credit rating agencies lost credibility with the mortgage meltdown, but never paid a price and most likely still hold the position of ultimate arbiter. Worse, most political decisions lately are based not on what makes the most sense, but rather what pleases “the market.” If (when) the agencies downgrade the US, the markets will authoritatively assert their displeasure. Only then will Congress roll up their sleeves and produce a viable lie, which they can pass as legislation to forestall the probably collapse until after the next election.
Yesterday, at a speaking engagement with the local Board, I told agents I thought it was about 50/50 that the US would be downgraded. Today, it’s more like 60/40 in favor. The markets are pricing this in to a degree, but I don’t think they really believe it’s going to happen. In any case, I don’t believe they’ve come close to pricing in the real cost of a downgrade. When they do, a safe haven won’t be equities or debt, it will be cash (for the reckless) and precious metals.
All of this presupposes that the zealots in DC don’t push the “nuclear” button. If you want to talk wild ideas: what if the Treasury decides to make a point by not paying some of the debt obligations, even though there is PLENTY of money to do so? An actual, “according to Hoyle,” default won’t drop our credit rating from AAA to AA, but to D…
July 29, 2011 — 2:09 pm
Brian Brady says:
…and yet, production coupons closed up 13 teenies, the highest 2011 levels yet.
July 29, 2011 — 3:01 pm
Jeff Brown says:
I’m somewhat of a outsider on this one. I suspect that rates might dip slightly due to increased demand from those around the world for ‘safe’ harbors, i.e. U.S. Treasuries.
Flip a coin, right?
July 29, 2011 — 3:28 pm
Dylan Darling says:
Flip a coin is right! Who knows… I don’t think rates will change drastically though. But its all speculation at this point. I think its crucial to our recovery for rates to stay low until the foreclosures and short sales aren’t dominating our markets.
July 29, 2011 — 3:59 pm
Brian Brady says:
“Flip a coin, right?”
Right. The safe bet is that rates jump 60-125 bp but I’m not seeing the panic. I’m just laying out the counter-argument to the obvious textbook scenario.
I’m quite certain I’d have a better chance at Del Mar this weekend than guessing how this one plays out
July 29, 2011 — 4:55 pm
Jim Klein says:
Forest, trees; there are almost no unknowns. Sharpies have known that a downgrade will lower treasury yields, due to a flight to safety. IMO it’s mostly priced in by now, but it doesn’t really matter. The short-term problems will come from contractual obligations dealing with the ratings of bonds used for collateral type purposes. It could be a huge problem for some, or none for others…Rule of Law can handle that.
It may be 60/40 for a downgrade, but it’s 98/2 at best for default. The only question is whether it’ll be through not paying bills or devaluation. Logic and history says the latter is far more likely, even as the former–like if it were done next week–might actually save the day. Numbers don’t lie, and the unfunded liabilities simply ain’t gonna get paid, at least not in anything like current dollars. Absent an extreme jolt next week, as in literally stopping 40% of the madness, it simply can’t be done, period.
Longer term, everything still rests on the other side of the equation—production. There is no reason to suspect that under the current system, the stifling of production will wane. Hell, I read a rumor that they’re even thinking of requiring CDLs for farm equipment; that’s probably just in case some people manage not to starve! Any way you cut it, the quiet stretch figures to be over soon. All we can do is try to guess what idiocy they’ll think of next, and whose blood they’ll lust to drink. Too bad that’s not so tough to figure out either.
Here’s safe investing—go long shrimp cocktails, short nails and wits.
July 29, 2011 — 7:58 pm
Jim Klein says:
And Brian, stop getting distracted. All you gotta do is write down a losing nag that had a good excuse, even better if it doesn’t show in the Form. It can’t get any easier than that.
July 29, 2011 — 8:10 pm
Brian Brady says:
“It can’t get any easier than that.”
Jim, I have to find the WSJ article that changed my horse wagering philosophy. A securities analyst ran every known “system” to discover that, over time, each “system” predictably lost 17%, which is the rough percentage of the house vig. This lends credibility to what grizzled track bettors call “womens’ bets” (number, silk colors, jockey’s name, etc).
Armed with the knowledge that each dollar bet has an expected value of $.83, my afternoons at Del Mar are now filled with less analysis, less deliberation, and an increased appreciation for the fairer gender’s contribution. 😉
July 30, 2011 — 8:59 am
Sean Purcell says:
“Flight to safety”
What an odd way to characterize the debt of a financially bankrupt company. Why? Because it’s the only game in town? I guess we’ll have to see, but lowering of the US credit rating will simply be a reflection of what the market already suspects. Hard to imagine not wanting a higher return once those suspicians have been “certified”…
I agree with Jim on the 98/2 chances for default and how it won’t be a “technical default”: devaluation. Wouldn’t that be the logical conclusion of most buyers of US debt, especially going forward? Again, argues for higher yields.
July 30, 2011 — 9:20 am
Jim Klein says:
Oh yeah, Sean; I should’ve put “flight to safety” in scare quotes. Too funny, really; still, that’s the way it is while we’re in a dollar-reserved currency. Much higher rates long-term are completely obvious, I agree. Tougher one: how many digits for bread?
Brian, I’ve seen how the crazy numbers work; there are days that’s the wisest for sure. Still, I think you’re wrong because parimutuel is parimutuel. Being 17-25% better than everyone else seems like a righteous challenge to me. Take a look, like literally, at who you’re actually betting against when you walk in, and see if that doesn’t build your confidence!
July 30, 2011 — 9:19 pm
Wayne says:
Do they have the political will to “cut,cap, and balance” … probably not.
Eventually somebody has to hold the line or the crisis will be even more real than it is now.
July 31, 2011 — 1:02 pm
Sean Purcell says:
I know that I’ve become a cynic… perhaps too much so; but I don’t see politicians ever actually “holding the line.” It goes against their best interests (vote buying) and that’s just not a natural outcome of human nature.
The author of today’s post is fond of Milton Friedman’s quote: “The way you solve things is by making it politically profitable for the wrong people to do the right things.” But I’ve yet to hear how that plays out in the real world. What is more “politically profitable” than being re-elected?
Here’s the problem with “cut, cap & balance” as I see it:
Cutting is needed (obviously), so let them have at it. What’s that now? Everyone talks about cutting, but any actual cuts are ten years hence? Go figure…
Capping, on the other hand, is a fool’s errand. What cap, limit or ceiling have you seen Congress (or President – any of them) honor? Let’s start with the most basic limiter of all: the Constitution. Heck, these people actually took an oath to uphold that bit of restraint. How they doing so far? Creating a”cap” is just kabuki theater designed to ease people’s worries (read: attention) until those in power can safely go back to spending money to buy votes. This is not rocket science; those handed power do it every day by taking a budget item “off-budget” or redefining words to mean something different than what they mean… it would be funny if it weren’t so fatal.
Balance (as in Balanced Budget Amendment) is the scariest idea of all. What if Congress actually said “Well, we’re too incompetent to run this company, so will you please create a law forcing us to recognize basic laws of economics?” What if we did? What would happen (beside witnessing possibly the greatest example of spineless leadership since Mr. Neville Chamberlain signed the Munich Agreement)? Every piece of legislation, every action of the Executive and the Legislative branches, every budget item and debate, would be open to legal challenge as unconstitutional (under the Balanced Budget Amendment) and subject to scrutiny by the Judicial branch. It would forever unbalance the three branches of government, creating an imperial judiciary.
Cut (sure, go ahead), Cap (smoke & mirrors), Balance (probably the final nail in the coffin of the US Constitution). The crisis can’t get any more real… what it will eventually get is more realized.
July 31, 2011 — 3:24 pm
Hamid says:
Interesting times we are in, they supposedly have a deal now but it hasn’t been voted on yet. I can’t imagine rates going up too much, the real estate market is still too saturated with distressed sales.
August 1, 2011 — 5:49 am
Hamid says:
We don’t need any more pressure on the market, with all the distressed sales we need rates to stay where they are so we can get through this inventory asap.
August 1, 2011 — 5:52 am
Wayne says:
“Everyone talks about cutting, but any actual cuts are ten years hence?”
We need cuts right now…. Major Cuts…. no doubt!
August 1, 2011 — 7:31 am
Bob says:
I actually believe that a drop in the credit rating will indeed push interest rates up. I agree that there is a lack of confidence in the rating agencies however people seem to make rash decisions in spite of using good sense.
August 1, 2011 — 10:19 am
Robert Worthington says:
I’m thinking the will go up. If and when, rates do go up, then housing prices must come down. Another bubble in itself?
August 5, 2011 — 4:09 pm