The death of the Treasury benchmark

July 26, 2011

James Saft is a Reuters columnist. The opinions expressed are his own.

A U.S. default or debt downgrade may set off market fireworks but the longer-term effects of the death of Treasury bonds as a universal benchmark of risk may ultimately be more significant.

The U.S. appears to be slouching towards a self-inflicted debt crisis, with Democrats and Republicans unable to agree a plan to lift the $14.3 trillion debt ceiling by the Aug. 2 deadline.

Even if such a deal is agreed, it may not be radical enough to satisfy ratings agencies, notably S&P, which has said it wants to see a $4 trillion reduction over 10 years. A deal on that scale seems unlikely by the deadline, meaning we may be looking at another round of negotiations in 2012, an election year.

All of this may be enough to push S&P or one of its peers into an exemplary downgrade even if there is no technical default, stripping the U.S.’s AAA status and risking an unpredictable chain reaction in global markets.

Even if none of this happens in the next few weeks, the larger truth is that the illusion that the U.S. is a solid-gold credit which can never default is lifting.

That concept — that the U.S. is the best possible sort of borrower, one that can never default — has been at the heart of the global financial system for decades. Investors have believed, mistakenly it turns out, that they can measure risk by comparing all credits to the U.S. Treasury benchmark. This has been an incredibly useful convention, giving financial markets a foundation upon which to build riskier investments, a means to gauge risk and a harbor to flee to when seeking safety.

The Treasury market’s ability to serve all of those functions will diminish over the coming years, not because the U.S. will default — it probably won’t — but because the words “permanent” and “risk-free” have meaning and everyone will now know they cannot be applied to Treasuries.

That’s bad for Treasuries, and will drive the cost up at which the U.S. can borrow, but it may prove to be worse for everybody else. A huge preponderance of all of the decisions and investments made in financial markets rely, directly or indirectly, on the concept of a risk-free rate.

The issue is not simply that the world will extract a higher rate of interest from everyone else because the U.S. is a less good credit, but rather that the process of figuring out who is a good credit and how to calibrate the relative difference of risk between one borrower and another is now infinitely more complex.

And, as complexity in systems is expensive, the overall cost of credit will rise.


That’s actually probably a good thing, as the illusion of a risk-free U.S. borrower has led to an enormous misallocation of capital globally, from the fighting of wars the U.S. could not afford to the building of marble-clad bathrooms its consumers did not need.

Good it may be in the long term, but good it will not feel as it is happening.

My guess is that actually poorer credits will suffer more than Treasuries in the immediate aftermath of a U.S. credit event. If you no longer know where you are, you will try to take on less risk, like a driver who suddenly finds themselves in an impenetrable fog.

Think, for example, of the largest banks: people have been willing to lend them money based on the assumption that they are backstopped by the government, a AAA risk. The risk of lending to a too-big-to-fail bank does not rise in step with the rise in risk of lending to the government, but far faster.

Eventually, many corporations may be able to borrow more cheaply than the U.S. Already it is cheaper to buy default insurance on some large U.S. corporations than on the U.S. itself. The larger point is that everybody’s cost of credit will rise, because people are discovering that there is far more risk in the system than they imagined, and because the price of discovering that risk is far higher than we all assumed.

There is an irony too in the potential for a ratings agency to deal a key blow to the U.S.’s illusion of credit invulnerability. While some of the work done by ratings agencies was solid and some worse than useless, the fact is that investors before the crisis became far too reliant on ratings, and gave them far too much credence.

As faith in credit ratings ebbs, the cost of credit should rise to reflect the higher costs of actually doing your own analysis.
Shorn of our assumptions, we are all likely to charge each other more to borrow, slowing growth even further.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)


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I’m so angry at these idiot congressional politician leaches. We are all to blame for many many things. But this current arrogance is unthinkable in view of what we have already lost and will continue to lose. Surmountable problems amplified by arrogance to the point they become destructive.

Posted by SeaWa | Report as abusive

There are multiple factors converging to place a nasty ‘hit’ on Treasuries and almost all other sovereign debt. The wake-up call regarding how much risk is really inherent in sovereign debt is happening too loud and too fast. Investors are going to panic.

I am reminded of the wake-up call on mortgage-backed assets that began ‘ringing’ in July 2007 with the subprime crisis. As it turned out, almost anything that had any connection with the word “mortgage” turned toxic.

That’s what is going to happen with sovereign debt – and very soon.

We’ve got the rapidly rising risk of a U.S. downgrade, and a real default by the government after 8/2. Even if the U.S. hobbles along and pays China before it pays retirees and contractors, how long can investors feel confident about getting their money out of their Treasury holdings when the domestic social order in the U.S. is plunged into disorder and strife, as it most certainly will be if we pay China (bond holders) but maybe not our own people?

We also have the resurgence of contagion across Europe – which is all about sovereign debt and the huge risks involved in owning it. The Greek bailout only calmed contagion for less than one week. It’s powerfully resurgent now.

Sovereign debt is the ‘subprime paper’ in the new global crisis that is rapidly emerging. Sovereign debt is going toxic.

German banks are slashing their holdings of Greek and other sovereign debt. The wave has already begun.

NOTE THIS: If the U.S. joins the tainted sovereigns club, which it can be argued that it already has, then global confidence in ANYTHING sovereign will be profoundly undermined. We’re flicking our Bics next to the bomb fuse.

Posted by NukerDoggie | Report as abusive

[…] The pool of AAA-rated instruments is dwindling.  (FT Alphaville, Reuters) […]

Posted by Wednesday links: quality and consistency | Abnormal Returns | Report as abusive