From the current print edition of National Review:

Downgraded President

I shall not want capital in Heaven / For I shall meet Sir Alfred Mond / We two shall lie together, lapt / In a five per cent. Exchequer Bond.

— T. S. Eliot, “A Cooking Egg”

On Feb. 7, 2010, the secretary of the Treasury, Timothy Geithner, was asked whether persistent deficits put the United States in danger of losing its AAA credit rating. “Absolutely not,” he said. “That will never happen to this country.” A little over a year later it did, when the ratings agency Egan-Jones downgraded the United States to AA. 

Egan-Jones, though a member of the cartel of ten credit-rating agencies recognized under federal law, is not one of the Big Three (Moody’s, Standard & Poor’s, and Fitch), and its ratings do not generate the same kind of headlines. But it is an interesting firm, and not beloved by the other agencies. One reason for that is the fact that it makes its money by charging bond investors for its information, rather than by charging bond-issuers for ratings, and makes much of this practice, accusing its competitors of having a conflict of interest built right into their business model. Further, the firm’s principal went to Congress in 2008 to accuse the ratings industry of having engaged in a race to the bottom for credit standards, which did not make him popular. In some investors’ minds, these are reasons to regard Egan-Jones as more credible than its household-name competitors. In any case, the Big Three themselves have warned that, absent a credible deal to rationalize U.S. public finances, a downgrade is likely. And their downgrades would have consequences. 

The judgment of the Big Three agencies is taken as gospel by practically no serious investor; their ratings are largely of technical and legal concern. The role of the credit-rating agencies is not to provide guidance and insight to the marketplace, but to certify the findings of the marketplace as conventional wisdom. But their role is important because of the way banks, insurance companies, pension systems, and other financial firms are regulated. (Contra Rep. Barney Frank et al., our problem was never deregulation; our problem was, and is, regulation written and enforced by dopes.) One of the regulations faced by banks is the “capital requirement,” which mandates that a bank must hold a certain amount of capital in reserve to offset its liabilities. But not all capital is created equal, and so $1 million in AAA bonds offsets more than does $1 million in AA bonds. Insurers and pension funds operate under similar restraints. 

Financial firms hold trillions of dollars in Treasury securities, and a downgrade to AA (or worse — Greece is now down to Ca) would have meaningful consequences, though not necessarily catastrophic ones. Financial firms would be sent scrambling to raise new capital, in a market that would no doubt be panicked by the fact that the United States of America and its once-unshakable Treasury bond have been caught with their fiscal pants down. This would be in a sense a replay of the 2008 credit crisis, in which declining mortgage securities forced banks to raise capital, which they did by selling those same declining securities, which drove values down further still, necessitating the raising of more capital, in a kind of subprime death spiral.

The impact of a Treasury downgrade is likely to be wider, but possibly not so deep or so radical — whereas there was no bottom under mortgage securities, investors are more likely to hold on to their Treasuries until maturity and redeem them than to dump them in a fire-sale panic — so long as the prospect of a real default remains remote. 

Beyond that, the immediate result of a downgrade of Treasury bonds to AA is anybody’s guess.

There are a number of major economic powers, Japan among them, whose government bonds are AA or lower. But none of those economies accounts for 25 percent of the planet’s GDP. 

. . . What we will learn now is whether any of this will prove sufficient to forestall a downgrade and the disorder threatened by it, whether Republicans can achieve long-term entitlement reform, and whether Barack Obama will be remembered, to emend a phrase of Daniel Hannan’s, as the downgraded president of a downgraded nation.

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