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League of Power

The League of power


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Running for Cover

Kevin Raymond January 17, 2011 Freedom by Friday No Comments on Running for Cover

A few weeks ago I wrote about the impending crash in the muni markets. We’ve seen the first leg down already as Muni costs are far above those of Treasuries. But, that second leg down, the one after which it will be time to buy, may occur sooner than later. Many states and municipalities are broke, floating on debt and deficit financing. That party is almost over and states and local municipalities are getting ready to face reality. The reality is this: cut spending or raise taxes…or as in the case of Illinois, do both and run for cover.

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Illinois Governor Pat Quinn announced a proposed 75% tax hike on state residents to help pay for the $15 billion deficit faced by mounting debts. The reaction to his idea was so favorable, he had to exit the State’s Capitol building through the basement exit. Illinois’ troubles are huge, but they pale in comparison to those of places like California whose budgetary mismanagement would make many a banana republic proud of the company.

Behind the Curve

Last week Moodys and S&P, the ratings services made some comments about the AAA Sovereign Rating of the USA. Here is an excerpt of the comments and some related perspective by Dave Kansas of the Wall Street Journal:

The two leading ratings agencies haven’t made any formal moves to threaten America’s vaunted top-notch AAA credit rating. But they continue to chirp about the possibilities.

At a Paris conference, Carol Sirou, head of S&P France, opined: “No triple-A rating is forever.” Well, Rome did lose its top rating sometime after the Visigoths made hay. Ms. Sirou also made the daring claim that S&P can’t “rule out changing the outlook.”

Not to be outdone, Sarah Carlson, senior analyst at Moody’s, told Dow Jones: “We have become increasingly clear about the fact that if there are not offsetting measures to reverse the deterioration in negative fundamentals in the U.S., the likelihood of a negative outlook over the next two years will increase.”

So, if America continues to binge for a couple more years, then Moody’s might start considering making a move.

Threatening the U.S. AAA rating is a great headline grabber. But the folks with actual money seem particularly nonplussed by the noise. In the bond market, the U.S. 10-year Treasury yields 3.361%. Germany, everyone’s favorite fiscal prude, sports 10-year yields at 3.048%.

In the credit-default swap market, where investors buy insurance against a possible default, it costs $41,000 to insure against default of $10 million in five-year U.S. debt. By comparison, such insurance for Germany is $60,000 and for Greece is $958,000.

First, I would like you to pay special attention to the price of insurance against default. As I mentioned in previous weeks, and more pointedly last week, the US Bond markets are what matter when it comes to gauging crises. Insurance on default for US five year is trading at a pittance. That implies that the likelihood of a default or even a downgrade is pretty close to zero.

Both Moodys and S&P have been crowing about this issue for the past couple of years. They have acted to reduce the ratings of places like Portugal, Greece, Ireland and Spain to be sure…but those actions came well after the crisis was already underway. If you recall, it was these same ratings agencies that talked up the ratings of bonds secured by mortgages during the housing bubble and only acted to downgrade once the obvious was at hand.

Moodys and S&P are both behind the curve. Maybe they are scared of the implications of a US debt downgrade – after all, the ensuing panic would surely affect their own revenue and profits stream! Technically the US is already bankrupt. Our debts and obligations, foreign and domestic are much greater than our assets to the tune of about 4 to 1. Of course, in the scheme of things that is quite tame compared to the 30 to 1 leverage the government allowed the banks to take on until the recent crisis.

If there is any question about whether you should be accumulating hard assets like commodities, the non-action by the ratings agencies should cure you of any indecision. Waiting for the US AAA rating to be removed as a “signal” to panic is the last thing you want to do. When it happens, it will be way too late and as we all witnessed from the recent crisis, it always makes sense to buy insurance before the storm.

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