As we approach Treasury’s debt-ceiling deadline, attention has shifted from the risks of a default on Treasury debt to the risk of a downgrade of U.S. credit. Many are asking whether a downgrade could itself lead to a financial crisis. With the example of 2008 still fresh in many minds, the question has become: Would it be as bad as the Lehman Bros. bankruptcy?
Some market observers speculate that a downgrade would be a non-event: Japan, for example, went from a rating of AAA to AA without much drama. Others suggest that a downgrade would increase Treasury’s borrowing costs by $100 billion a year or more, making our already unsustainable deficit trajectory even worse.
There are no rules to define what is systemic and what isn’t — or to accurately predict the consequences of an economic shock. Each crisis is unique. How exactly it will affect financial markets, companies and our economy is impossible to know. Nonetheless, recent examples offer guidance.
In 2008, a number of once-cherished beliefs were turned upside down: (1) that home prices in America would never fall; (2) that AAA-rated subprime securities are sound; (3) that a major investment bank would never fail. Consumers, investors and companies allocated capital according to these truths. When the beliefs were revealed to be false, massive shocks were inflicted on the economy as financial markets rapidly adjusted to account for these new risks.
Banks had to reduce their leverage and rein in lending. Companies froze investment. Consumers cut spending and started saving. As a result, the economy plunged into recession, and millions of jobs were lost. Unemployment shot to 10 percent.
The question now is whether U.S. Treasury bonds, which anchor the global economy, really are the gold standard, the risk-free financial instruments they have been trusted to be. What will happen if that truth is revealed to be false?
Four factors in particular can help assess the magnitude of the financial impact from an undermined truth:
(1) How strongly is the belief held?
In 2008, investors around the world generally believed that major U.S. investment banks were so large they would never be allowed to fail. In the six months leading up to Lehman’s bankruptcy, however, it came under increased funding pressure and its stock price slowly collapsed. Markets were not completely convinced that the government would have the will or the ability to save Lehman; otherwise investors would have continued lending to it, as they did to Fannie Mae and Freddie Mac, which had no trouble borrowing money before they were rescued only days ahead of the Lehman bankruptcy.
By comparison, U.S. Treasurys have been defined for decades as the risk-free financial instrument throughout global financial markets. Faith in Treasurys is far stronger than it ever was in Lehman Bros. This suggests a far bigger shock than Lehman if this truth is proven false.
(2) How big an asset class does the belief support?
U.S. Treasurys are a $14 trillion market — the single biggest security market in the global economy. In comparison, Lehman had approximately $600 billion of liabilities before it failed, less than 5 percent of the size of the Treasury market. Treasurys are held by virtually all 8,000 banks in America and nearly all insurance companies, corporations, pension plans and millions of individuals’ 401(k)s. This scale suggests a far larger shock than Lehman.
(3) How wrong was the belief?
Here, Treasurys are not as bad as Lehman. Even if the U.S. credit rating is downgraded, almost no one believes we will actually default on our debt. The United States is not entering bankruptcy, and its debt is not junk. Lehman debt ultimately proved to be worth a fraction of its face value. To some, this suggests a U.S. downgrade would produce a more modest shock than Lehman. But a small deviation from a cherished belief can be as shocking as a large deviation from a weaker belief.
(4) What is the economic context in which the shock is taking place?
Although the United States is technically no longer in recession, the U.S. economy is growing slowly. Unemployment remains at 9.2 percent. Europe is awash in its own fiscal crisis, and much of the developed world is struggling. When Lehman collapsed, U.S. unemployment was at 6 percent, but the economy was contracting and housing markets were plummeting. The global economic context in September 2008 was probably worse than today, but our economy remains vulnerable.
These factors suggest that a U.S. downgrade has the potential to be as bad or perhaps worse than the Lehman shock. The more strongly held a belief, and the larger the asset class it supports, the greater the potential damage to the economy when the belief is turned upside down. We may not be certain what will happen if U.S. credit is downgraded, but there is no upside to finding out.
The writer, a managing director of the investment management firm Pimco, served as an assistant Treasury secretary during the George W. Bush administration. He established and led the Office of Financial Stability and the Troubled Assets Relief Program until May 2009.
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