Last week I described what the prospective default by the US does to the bond markets in terms of spread relationships with supposed “risk free” rate of return represented by government bonds in a research note, “Black Friday and the end of risk free returns”:
The benchmark treasury curve has been been loosed from the bounds of earth and is now a relative benchmark, where “superior” corporate credits can and will be priced through Treasury and agency yields on a regular basis. If this sounds a little too much like the world of quantum physics and Steven Hawking, all we can do is borrow a line from Joan McCullough at East Short Partners: ‘Get used to it.’
Another friend and mentor, Alex Pollock of the American Enterprise Institute, noted in a letter of the Financial Times that there is no such thing as a risk free rate of return. To that point, 100 years ago the United States had no international credit rating — or credit — and was forced to operate through the great New York banks when it came to international payments. How quickly we forget.
By the end of WWII, the US discarded the proposal of J.M. Keynes for a competitive, multilateral currency system and instead took a page from the Roman Empire and equated the dollar with gold. This symbolically and functionally associated the dollar with risk-free assets, at least for a few decades, but now the size of the US federal debt and commitments makes this implication indefensible as a practical matter.
From Nixon’s closure of the gold window in 1972 through to the present day, the US has been on a steady financial course toward default — even if investors do not want to believe it. Now we are “thinking about the unthinkable,” to borrow the title of Herman Kahn’s seminal 1968 book about the reality of nuclear war, only now with respect to financial default in the US as well as in the EU.
For bankers attempting to model forward loss rates and capital requirements, as is now required by federal regulators, how to model sovereign risk raises some thorny issues. Since it is now possible for a nation like the US to ponder default for purely political reasons instead of because of an incapacity to pay, should banks still carry such risk exposures at zero weighting for Basel III capital purposes?
At present, the Basel III framework does not require any capital or reserves for sovereign debt of a certain credit rating. “Lending to AA-rated sovereigns still carries a risk-weight of zero,” the Economist noted last September in a prescient article. So even if the US was downgraded as a result of the childish manner in which fiscal issues are being mismanaged in Washington, banks would still not need to put any capital behind Treasury bonds.
But the fact is, that downgraded or not, investors have looked at the US as a weakening credit for many years. The spread to purchase five-year protection in the market for credit default swaps is now 68 basis points or 0.68% per year. If you compare the ratings scale used by Moody’s and S&P to describe probability of default, a 68bp spread in CDS is roughly equivalent to a “BBB” bond rating. It seems that in the minds of foreign investors, at least, the US is already a lower tier investment grade credit — as much for the ability to pay as for the willingness to enforce reasonable standards of national governance.
At the end of the day, investors looking out over the five year horizon of a CDS contract must ask whether they think the US fiscal situation and the purchasing power of the greenback are likely to improve in half a decade’s time. The answer regrettably is no, if the latest “budget deal” from Washington is any measure. It might be better for Congress to miss the debt ceiling vote, at the end of the day, if it makes the subsequent discussions more purposeful and serious.
For bankers and regulators seeking to enhance the safety and soundness of financial institutions, the new revelations about the possibility of default in the US and EU raise the possibility that top-quality corporations will be trading at tighter spreads and superior credit ratings than sovereign states. Perhaps far from being a surprise, the relatively better management and governance of the best global enterprises may augur the demise of the 19th century nation state. Should Basel III be adjusted to recognize the reality in the marketplace? Heaven forbid.