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Credit Insights

Thinking Through the Implications of a AA Treasury

We expect S&P's recent action was only the first shot across the bow and there will be further warnings.

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Analysts, politicians, and pundits have been espousing their view for quite some time that the United States government is on an unsustainable financial path, but it still was startling last week to see in print that the credit rating for the United States was placed on negative outlook. As the rating was changed to a negative outlook and not a negative watch, we do not expect a potential downgrade would come in the near future.

Based on our reading of Standard & Poor's press release, it appears they are contemplating up to a two-year time frame for U.S. officials to work out a comprehensive plan before transitioning the rating to a negative watch and possible subsequent downgrade. However, the 2012 elections may complicate the ability for policymakers to arrive at a reasonable plan within this time frame; such a plan must be comprehensive enough to reduce the deficit, limit the growth of additional indebtedness, and address the country's entitlement programs. In order to accomplish this goal, each party will have to negotiate in good faith and will require each side to be willing to sacrifice some of their political priorities to reach a comprehensive solution.

Unfortunately, we expect that this is only the first shot across the bow and that there will be further warnings that time is beginning to run out to address these issues. Based on the dollar's status as the global reserve currency and the sheer amount of U.S. debt outstanding, there will be further forewarnings from other sovereign and international entities. From here, for every month that goes by without progress toward a solution, we expect there will be increasingly more pressure for the U.S. to stabilize its finances in order to maintain its AAA rating (and in conjunction stabilize the dollar) to ward off the previously unthinkable--a downgrade of the United States of America.

The Treasury market, however, was unimpressed by the outlook change as the 10-year and 30-year bonds only backed off 4-7 basis points on the news. By the end of the day, Treasury bonds were actually 1-3 basis points tighter as the sell-off in the equity markets drove the flight to safety trade, which overpowered the outlook change.

At the end of the week, the 10-year and 30-year bonds ended unchanged compared to the prior week at 3.40% and 4.47%, respectively. While we don't believe there will be any drastic near-term effects on the credit market, over the next few weeks we will delve into some of the potential implications for the corporate credit markets and certain sectors if the U.S. Treasury bond is no longer a risk-free security (and consequently no longer the risk-free rate).

Bank Capitalization and U.S. Credit Risk
One of our first concerns from a possible downgrade was what the implications were for the amount of capital a bank would need to hold against positions in Treasury bonds. Our concern was that if a bank had to hold additional capital against AA rated sovereigns versus AAA sovereigns, then a bank would require a higher interest rate to make the same return. Based on a speech given by Herve Hannoun (deputy general manager, Bank for International Settlements) in November 2010 called "The Basel III Capital Framework: a decisive breakthrough," it appears that banks will not need to hold any capital against U.S. Treasuries under Basel III. Interestingly enough, AA sovereigns also carry a zero risk weighting. According to Hannoun's speech, "Sovereigns: the sovereign debt crisis of 2010 has shown that the zero risk weight assumption for AAA and AA rated sovereigns under the standardized approach of Basel II did not account for the dramatic deterioration in the fiscal and debt positions of major advanced economies. These exposures are still considered as low-risk but certainly not totally risk-free." Based on this, it appears that a downgrade of the U.S. to AA would not force banks to hold capital against Treasury bonds.

When considering the repurchase markets and AAA structured products, these are already being adjusted to require additional capital under Basel III. If the U.S. goes to AA, and that by itself does not require additional capital, then it appears there will not be further capital requirements for repurchase agreements associated with U.S. Treasuries. Again from the same speech:

OTC derivatives (under CSAs) and repos: the Lehman and Bear Stearns failures demonstrated that the very low capital charge on OTC derivatives and repos did not capture the systemic risk associated with the interconnectedness and potential cascade effects in these markets.

Senior tranches of securitization exposures: financial engineering produced AAA-rated tranches of complex products, such as the super-senior tranches of ABS CDOs. These proved much more risky than what would be expected from a AAA exposure. The preferential risk weight of 7% for those super-senior tranches was too low, and the risk weight has now been raised to 20%.

For assets with medium risk weights, one could cite the following examples:

--Residential mortgages: 35% risk weight under the standardized approach. For highest-quality mortgages: 4.15% risk weight (IRB approach)

--Highly rated corporates: 20% risk weight under the standardized approach. For best-quality corporates: 14.4% risk weight (IRB approach)

--Highly rated banks: 20% risk weight (standardized approach)

The short story here is that it appears under Basel III there would be little to no effect on capital requirements of a downgrade of the U.S. to AA. Obviously, the market as a whole might have a different opinion, but under Basel III it does not appear that there would be a change.

Europe
European corporate credit spreads held up remarkably well last week and were stable to only marginally weaker in the face of continued deterioration in sovereign credit spreads. Investors continued to dump Greek, Irish, and Portuguese debt as the 10-year bonds of each country hit new lows. Greek 6.25% Notes '20 fell 3.5 points to 58.75 resulting in a 14.73% yield (+1155 basis points over German bunds). Irish 4.50% Notes '20 fell 3.75 points to 68, resulting in a 10.08% yield (+702 basis point spread), and Portugal 4.80% Notes '20 fell 3.5 points to 71, resulting in a 9.73% yield (+656 basis point spread).

As the long dated debt fell, the credit curve for each country continued to invert further as the market is pricing in an ever-increasing probability of a near-term default or restructuring event. As we mentioned last week, at these levels, the bonds are no longer trading on the basis of yield and spread, but are trading on a probability weighted basis of par based on whether the bondholders will ultimately have to take a reduction in principal in a workout and how much that haircut could potentially be. In contrast, investors fled to the safety of German Bunds, which tightened 12 basis points to 3.26%.

The New Issue Market
As expected, the new market slowed to a crawl for the holiday-shortened week. While new issue should pick up next week from an almost nonexistent rate, it will still be on the low side since we expect the market's focus will be on first-quarter earnings announcements.

We typically don't comment on Treasury bond auctions, but last week, the auction for five-year Treasury Inflation Protected Securities (TIPS) resulted in a negative yield. This means that investors were willing to purchase a security in which their only source of positive return would be an increase in principal indexed to increases in the Consumer Price Index (CPI). In order to break even as compared to straight Treasury bonds that pay a fixed coupon, CPI will need to average the same amount as the yield on the five-year Treasury bond, which is currently 2.11%. While Federal Reserve officials continue to espouse their current view that any near-term inflationary pressures in food and energy will be transitory, inflation expectations appear to be increasing among investors. We will follow up over the next few weeks with additional detail on market-implied inflation expectations using the five-year forward five-year break-even rate as our preferred method.

Click here to see more new bond issuance for the week ended April 22, 2011.

David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.