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August 2011
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The impact of a US debt downgrade

Friday’s downgrade by S&P of the US sovereign debt, from AAA to AA+, was an extraordinary event in modern finance.  As reported by WSJ, the is the first time the US government debt lost its AAA credit rating in more than 70 years.

What does this mean for the US and world economy?  Here is an insightful interview of Nouriel Roubini (aka Dr. Doom), Christina Romer (former Chairman of President’s Council of Economic Advisors), and Jim Bianco (president of Bianco Research).

 

US Treasurys are widely held as collateral by many financial institutions around the world.  The biggest risk is a sharp fall in value of US Treasurys may trigger another credit dry-up in the financial system.  This is perfectly summarized in the following paragraphs in the WSJ piece:

J.P. Morgan Chase & Co. analysts estimate some $4 trillion worth of Treasurys are pledged as collateral by borrowers such as banks and derivatives traders. If that collateral isn’t considered as high quality by lenders, the borrowers could be required to cough up more cash or securities to put the minds of lenders at ease.

That could force investors to sell off other assets to come up with the money. In a worst case scenario, credit markets could seize up, as they did during the Lehman Crisis.

Money market funds held by millions of Americans hold some $1.3 trillion in securities directly or indirectly exposed to Treasury and government agency securities, as well as short-term loans to financial institutions, known as repos, which are backed by Treasurys. Experts say that the downgrade won’t force money market funds to sell. But there are still risks.

If Treasurys tumble in value, funds will be forced to mark down their holdings, raising the potential for some to “break the buck” as the Reserve Primary fund did during the worst of the financial crisis.

 

Lastly, let’s hope China and Japan won’t sell: a key concern will be whether the appetite for U.S. debt might change among foreign investors, in particular China, the world’s largest foreign holder of U.S. Treasurys. In 1945, foreigners owned just 1% of U.S. Treasurys; today they own a record high 46%, according to research done by Bank of America Merrill Lynch.

In theory, China and the US are on the same boat: a fall in US Treasurys won’t do Chinese any good.  But that’s only theory on paper: people do all kinds of things when they panic.  Same thing applies to governments.   Personally, I think the chance is very slim for Chinese to dump US Treasurys.  But always be reminded “what could happen” – Re-watching this 2009 interview of Julian Robertson of Tiger Management will help you appreciate the worst scenario.


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