All That Glitters / Capital Markets Are Giving S&P the Finger

Investors, and Barack Obama, still have faith in American bonds.

A question for financial-market novices: If a famous, international credit-rating company surprisingly announces the downgrading of an asset, what would you expect to happen to its price on the market? The textbook answer: It's price will go down. The real answer, in the markets: The price of the asset goes up - and sharply.

This is what happened at the beginning of last week to the most important, liquid and widely distributed security in the world - 10-year U.S. Treasury bonds. On Saturday, August 7, Standard & Poor's announced its decision to downgrade - for the first time in history - the rating of U.S. Treasury bonds from AAA to AA +, and to posit a "negative" forecast for the American empire.

Obama - Reuters - 14.8.11

The market, nevertheless, reacted in the complete opposite direction: Treasury bond prices soared, closing the week with a nearly unprecedented gain.

In actuality, the U.S. Treasury bond is the most popular security in the world. Individuals, countries and companies are prepared to lend Uncle Sam money for a period of 10 years and in return to get an unlinked yield, in dollars, of only 2.2 percent, with an inflation target of 2-3%.

This means the investors do not get real yields but they are still grabbing the goods. What is happening here?

And this is not the end of the strange ratings story. The opposite is happening in Europe. Germany and France continued to enjoy the perfect AAA rating, and one would have expected that in the wake of the American downgrade, their bonds would have enjoyed demand and an influx of money. However, the exact opposite transpired: The prices of their bonds went down.

So what is happening here? Have the markets completely lost their faith in the ratings agencies and in the meaning of their ratings?

There are definitely those who think so. U.S. President Barack Obama and all his top administration staff were boiling mad on the weekend of the S&P decision. They argued that the decision was mistaken - both technically, because of a mistake in the calculations, and in principle. Noted investor Warren Buffett hastened to declare that the United States not only deserves an AAA rating, but that if it were possible to do so, he would expand the rating scale and give it AAAA.

On Tuesday, a private broker by the name of Lucy Nobbe hired a private plane to circle over the S&P offices in New York with a banner stating: "Thanks for the downgrade. You should all be fired." And why? Because in her opinion, the downgrade has to do only with a political issue and its effects on the economy could be dire. The price of this protest, incidentally, was not outrageous: $1,500.

Objective economists have also been criticizing the downgrade. They usually hasten to offer the following argument: The rating companies destroyed the American economy and caused the financial crisis of 2008 when they gave a rating of AAA to all the mortgage-based junk bonds they were asked to rate, for a fee of course. Now, the economists are saying, the rating companies are making the opposite mistake: They are downgrading without sufficient justification and, in so doing, they are causing a rise in financing costs in the American economy and are dragging it into a recession.

Other economists are offering a different explanation for why the downgrading of the United States is fundamentally mistaken. Alan Greenspan, former chairman of the Federal Reserve Bank (and after the 2008 crisis admitted he had been mistaken in his understanding of the financial system ), said last week on television: "The United States can pay any debt it has because we can always print money to do that. So there is zero probability of default."

The fear: A 2008-style crisis

Despite all the anger, criticism and arguments, the bonds did not go up because of the rating downgrade - but rather despite the fact it was made public. The real reason for the increase lies entirely elsewhere.

The beginning of the week saw the emergence of concern that the European debt crisis is entering a new phase, that France, too, will have difficulty paying its debts, and that some banks in Europe are about to collapse.

The fear of an economic crisis became the fear of a financial crisis like the one the world saw after the collapse of Lehman Brothers in September of 2008, and investors from around the world began to sell off whatever looked risky to them - bank shares, for example.

As in every panic, they put their money in the only place that is considered liquid, familiar and still secure - U.S. Treasury bonds. A rating of just AA +? Linkage to a dollar that could weaken? Zero and perhaps negative yield? The investors don't care. In times of panic, all they want is to maintain the value of their money, at least in the short run.

A ludicrous game

Are the ratings companies still deserving of trust? Not really.

On the one hand, credit to S&P for having been the first to state explicitly that the leaders of the United States are not managing the deficit responsibly enough; but everyone already knew that.

On the other hand, S&P continue to play the game of rating companies in a ludicrous way, and nearly always downgrade only after the horses have bolted from the stable. See, for example, the collapse of the tycoons' securities on the Tel Aviv market last week that brought them to the double-digit yield that says: "Caution - risk of non-redemption."

Did we hear anything timely from the ratings companies? Clearly not; and this too is a kind of finger the market is giving the ratings companies, the tycoons and the institutional investors who bought their securities.