If U.S. Debt Downgraded, What Will Happen?

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Richard Bove, the sometimes controversial analyst at Rochdale Securities, ticks off a laundry list of problems that will be caused by a downgrade of U.S. sovereign debt in a note this morning. Interest rates will soar, as will inflation, the dollar will continue to fall and municipalities might be forced to raise tax rates. One wonders, How to protect client portfolios?

Since we're on deadline, pumping out the August print edition of Registered Rep., I offer Bove's short note below in its entirety without any editorializing from me!

Rochdale Securities' Bove writes this a.m.:

Not Understood

It is now becoming a real possibility that the United States debt may be downgraded. The government has spent years convincing the electorate that anyone associated with the financial system in the United States is fundamentally dishonest. Therefore, any comments from financial leaders concerning what the impacts of a downgrade might be are simply not believed. Thus, it is becoming increasingly possible the politicians want to see for themselves what will happen.

Hopefully, this will not become reality. However, what is at stake?

Interest Rates

If the debt is downgraded, the following entities are expected to pay more for money: The United States will pay more for funds and this will increase the deficit increasing the need to cut entitlement programs and increase taxes. Any recipient of funds from the United States will receive less. This means bondholders at one end of the spectrum, and the sick and the elderly at the other end.

Government agencies will lose access to the money markets at reasonable rates. This means that Fannie Mae, Freddie Mac, and Ginnie Mae among many government agencies tied to housing will have difficulty raising new monies at reasonable rates. This will increase the costs of owning a house. It will drive housing prices down further, re-igniting the housing default problem.

Municipalities who have tied a number of the debt issuances to base Treasury rates will see their cost of borrowing rise. This will increase their financial problems and could drive local taxes higher across the country as state and municipal governments seek new monies to pay for the higher interest rates.

There are many instruments in the private sector where interest rates are tied to the Treasury debt rates both explicitly and implicitly. The rates here rise also. This increases funding costs across all industry segments. It is tantamount to a significant rate rise and monetary tightening by the Federal Reserve in the midst of a weakening economy.

The Federal Reserve itself will be powerless to impact the cost of money in the United States.

Inflation

The value of the dollar will fall/is falling. This increases the cost of goods purchased from overseas. This drives inflation higher.

Value Adjustments

Holders of Treasury debt will experience a decline in the value of all of their financial assets.

Major holders of the debt outside the United States from China to the Arab states will see the value of their Treasury holdings fall in value. This will lower their desire to buy American debt and possibly increase their desire to sell it.

The banking system will be forced to lower the value of its security holdings. This will reduce their capital at a time when the government wants more capital in the banks. This will force the banks to shrink and they will remove credit from the United States economy as they do so.

Private holders of debt from money market mutual funds to private holders will also experience a decrease in the value of their holdings. This decrease wealth and may cause households and businesses to pull back from spending.

No one in power believes that any of these developments, and more, will occur and this makes them more possible. There seems to be a clear desire to test the theory as one politician is quoted as saying: ”The sun will come up tomorrow.”

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