The Moody's Ratings Gambit

The big business of the week is this week's pronouncement by Moody's that the U.S.' AAA bond rating may be in danger.

Credit rating agency Moody's (MCO) said Tuesday that the United States, along with 16 other countries, could lose their Triple-A credit rating if fiscal deficits and heavy debts are not effectively managed.

While Moody's analysts emphasized that the United States' Aaa rating is not under immediate threat, it did say the rating could be downgraded in 2013 if the fiscal position does not improve.

It should be noted that Moody's kept the bond ratings for mortgage backed securities, including those backed by the most extreme sub prime loans, also at AAA all the way until only weeks before the crisis. As they issue such a warning, it's important to note that their own credibility is not exactly perfect as well.

In fact, this is the second time this year that such a warning has been pronounced. The market was met with a similarly dire warning in June.

No one in his or her right mind really thinks that the United States will lose its "AAA" rating. The U.S. economy is still the world's largest with a GDP of over $14 trillion. The deficit may be rising, but if the recession ends soon, consumer and business spending should rebound. The demand for Treasury paper remains strong and the largest purchasers, especially China, have indicated they are still ready buyers.

Moody's reaffirmed its "AAA" rating on U.S. debt but added a caveat or two. According to Reuters, the future risks the Treasury faces could change fairly fast. A
Moody's official told the news agency, "That will happen for two reasons. Either our assumptions in terms of debt reversibility prove to be wrong. That is, in fact the U.S. government is unable to bring public debt back to a downward trajectory," or if the United States' ability to raise a large amount of debt at a low cost were to be put at risk.

In June, bonds responded by skyrocketing for weeks after. So far, that hasn't happened in bonds. Instead, stocks nosedived following the news.

If the U.S. bond ratings really were ever cut, that would be a total disaster. The very low rate in U.S. bonds is embedded in a perfect rating. Anything less than that would mean rates would shoot up. Because the U.S. Treasury bond is a precursor to almost all other interest rates: mortgages, car loans, student loans, business loans, etc., that would mean all those rates, too, would go up. A massive rise in all borrowing rate would put a massive hurt on our economy and cause another recession or slip us further into a current one. Furthermore, with more than twelve trillion in debt, our borrowing costs would begin to eat up a massive part of our budget.

Now, no one believes such a move is imminent. At the same time, it doesn't appear as though the present administration has any plans on changing their spending habits. If that's the case a drop in the bond rating is somewhere near inevitable. Our yearly GDP is about 13 trillion. Our debt will catch up with yearly GDP in 2011 or 2012. That's a psychological number and maybe the point at which our rating changes. That's what happened to Japan during their spending binge in the 1990's and their economy never recovered.

Still, a drop in the rating may wind up being a good thing in the end. It's possibly the only thing that will force the hand of politicians and turn them into fiscal hawks. That's about the only thing that will make fiscal responsibility reach critical mass. Such a monumental event will likely force all politicians to jump over themselves to be fiscal hawks. It will force the shrinking of the federal government as that would make it the only acceptable outcome. That will force our debt down. Soon enough, other rates will recover as the shrinking debt will mean that something will replace the U.S. treasury bond as the precursor rate. On some level, we may all want to root for this.