Reputation Recovery

The views expressed in this column are solely those of the author and do not reflect the views of SVB Financial Group, or Silicon Valley Bank, or any of its affiliates. 

What can you do when your good isn't good enough?
When all that you touch tumbles down?
'Cause my best intentions keep making a mess of things
I just wanna fix it somehow
But how many times will it take?
Oh, how many times will it take for me?
To get it right
To get it ri-igh-ight
- Glee Cast 

Overcorrecting is human nature.

Sometimes it is appropriate. When you take a corner too fast and are forced to "turn into the skid," you find yourself turning right with your wheels pointed left. Or if you miss an assignment in school and performing make-up work, it would likely pay to put a little extra effort in to help erase your teacher's memory of your first lapse.

But ratings agencies shouldn't overcorrect. Missing the boat on billions of dollars of mortgage securities should not lead to over-aggressive rate cuts on sovereign nations.

In this column back in April , I argued the case against a rate cut for the U.S. after S&P put the U.S. on "negative outlook." Now that Moody's* has followed suit by placing the U.S. on "review for possible downgrade," the possibility of a downgrade seems to be increasing.

The reason given (no surprise) is the "rising possibility that the statutory debt limit will not be raised on a timely basis...." This followed the ample warning Moody's gave the government back in early June when it announced a review would come in mid-July.

As part of their rationale, Moody's stated "there is a small but rising risk of a short-lived default."

The bond market disagreed wholeheartedly. When the markets opened Thursday after the Moody's announcement, short Treasury bills went negative yield immediately.

Think about that: You get downgraded and all of a sudden investors can't get enough of you! This may seem counterintuitive at first, but I believe it makes perfect sense once you realize everything possible will be done to avoid missing an interest or principal payment.

First, some facts:

• 60 percent of the U.S. budget is paid for with taxes while 40 percent is covered by borrowings
• Debt service of existing debt is around just 7 percent of the budget
• Section 4 of the 14th Amendment says in part "The validity of the public debt of the United States, authorized by law...shall not be questioned."
• Section 5 of the 14th Amendment says in whole "The Congress shall have the power to enforce, by appropriate legislation, the provisions of this article."
• The Treasury takes in about $175 billion in revenues each month — more than enough to pay principal and interest on existing debt for some time
• Government spending is around 25 percent of GDP today, up from the low 20s in recent decades

Given sections four and five of the 14th Amendment, defaulting on our public debt is the last course of action we will take.

So, it seems the government could cut back on a lot of expenditures before halting payments on Treasury securities. Health and human services along with defense spending and social security are the largest areas of government spending and would likely see cuts before we default on a single Treasury.

No matter how the government cuts back, it will have an enormous detrimental effect on the economy given its 25 percent overall share.

You could see a scenario where the Treasury continues to service outstanding debt, but the economy tanks as the Treasury puts away its check book.

Under this scenario, potential rate increases to cool the economy get put off even further into the future and the Fed perhaps invents a method for QE3, while Treasury bond payments continue to perform as normal. This would actually increase demand for Treasuries while continuing to limit supply.

Economics 101 tells us prices for Treasuries should rise in this case, which they did even to the tune of negative yields.

So, where does that leave the ratings agencies? Likely less than gleeful, as their overcorrection strategy has backfired.

*Not to be outdone, S&P subsequently placed the United States on "Credit Watch Negative" for much the same reasons. This is different than having a negative outlook in that credit watch situations are typically resolved within 90 days. It's possible this entire issue has been resolved by the time you read this, however the hangover effects could last a while longer.