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A Bond Rating Conundrum?


The mortgage market in US increased dramatically in size,especially starting late 2003 with sharp growth of the riskier subprime and Alt-A mortgage lending. Since the too-big-to-fail institutions couldn’t compete directly with Fannie and Freddie because of the GSEs’ access to government guaranteed capital and their roughly 40 basis points lower costs of borrowing,they instead moved along the credit curve, dealing in increasingly shaky mortgage loans that the GSEs had difficulty competing.

The S&P Downgrade
On Friday, after the markets closed on a high note, Standard & Poor’s decided to downgrade U.S. treasury debt. Monday morning opened with an enormous drop in the markets—caused surely in part by S&P’s move.

Was the downgrade unprecedented? Absolutely. Logical? Absolutely not. A bond rating is an estimate of the chance that the borrower will not pay back their debt fully and on time. To justify a downgrade, one has to show why the probability of default has increased. Has the chance of a US default increased in recent months?

As for the amount of debt itself, despite the budget battles and ongoing gap between revenues and expenditures, overall net U.S. debt is still quite low for developed nations—somewhere on the order of 68% of current GDP once the holdings by the Social Security Administration are factored out. Given low interest rates, the current cost of servicing the nation’s existing debt is less than 10% of all expenditures. There is clearly no threat of a default in the near term, even if the de bt ceiling had not been raised.

As for the pace of accumulation, it is impressive. At the current rate the net increase is roughly 8% to 9% of GDP. But if the economy grows at 2% in real terms and has 2% inflation, this only means that the debt accumulation as a percent of GDP will grow at 4% to 5% of GDP per year. And remember that the deficit is already shrinking due to the scheduled end of certain stimulus programs. Additionally, the Bush era tax cuts are due to expire at the end of 2012, bringing in additional revenue despite Republican opposition to tax increases (NOTE: if the Republicans take over the Senate and White House, these tax cuts would almost certainly be extended. Of course, one might presume that spending would also be cut although the record of George W. Bush would suggest otherwise. This might be reason for a downgrade, but it seems early for the S&P to call it). As such we are many years away from debt levels hitting the 90% or higher level that many bond analysts see as entering the danger zone.

CATEGORY: General Economy

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