Strategic Briefing | 8.9.2011 | The New New Financial Crisis

Why This Crisis Differs From the 2008 Version
The Wall Street Journal | Aug 9
There are three fundamental differences between the financial crisis of three years ago and today’s events. Starting from the most obvious: The two crises had completely different origins. The older one spread from the bottom up. It began among over-optimistic home buyers, rose through the Wall Street securitization machine, with more than a little help from credit-rating firms, and ended up infecting the global economy. It was the financial sector’s breakdown that caused the recession. The current predicament, by contrast, is a top-down affair. Governments around the world, unable to stimulate their economies and get their houses in order, have gradually lost the trust of the business and financial communities.

Will the FOMC Repeat the Mistake of September 2008?
David Beckworth | Aug 8
I hope not. As you may recall, the FOMC met a day after Lehman collapsed on September 16, 2008 and decided against lowering the federal funds rates. Yes, the Fed decided to keep its targeted interest rate unchanged at 2% just as the financial crisis was reaching its peak. Amazingly, the reason the FOMC acted this way was its concerns about inflation, which at the time were driven by commodity prices and reflected a backward-looking view of inflation. Had the Fed given more weight to forward-looking indicators like the expected inflation rate coming from TIPS and a host of other market indicators, the Fed would have realized the market was pricing in a sharp recession. Even though the Fed intervened more aggressively after this point, it never rose to the point that would restore current dollar spending to a healthy, sustainable level. The Fed, therefore, effectively tightened monetary policy at that time.
Global Bonds Gain $132 Billion Amid Stock Rout
Bloomberg | Aug 9
The worldwide retreat from stocks and commodities following Standard & Poor’s unprecedented cut of the U.S. AAA credit rating has driven the value of the global bond market to a record high. The market value of Bank of America Merrill Lynch’s Global Broad Market Index has increased $132.4 billion since the end of July to $42.1 trillion, the most in data going back to 1996. The index, containing more than 19,000 bonds sold by governments, banks and the world’s biggest companies, returned 1.09 percent this month as yesterday’s stock rout wiped out about $2.5 trillion in global equity values, extending total losses since July 26 to $7.8 trillion. While S&P said the credit worthiness of the U.S. was diminished when it cut the rating to AA+ on Aug. 5, Treasuries have surged. The yield on the benchmark 10-year note dropped today to as low as 2.27 percent, the least since January 2009. Investors are seeking the safest assets amid growing concern that debt crises in the U.S. and Europe and a manufacturing growth slowdown in the world’s two biggest economies may cause the global recovery to falter.
Which Rating Agency Downgraded the U.S. First? Not S&P
Donald Marron | Aug 8
The S&P downgrade of U.S. credit has understandably dominated headlines, but S&P was by no means the first mover. At least three other rating agencies had already downgraded the United States. Egan-Jones was the first Nationally Recognized Statistical Rating Organization (NRSRO) to downgrade. It lowered the U.S. rating from AAA to AA+ in mid-July. NRSROs are the companies that the SEC officially recognizes as credit rating agencies. They number ten in total, with Fitch, Moody’s, and Standard & Poors the most famous (or, in some circles, infamous). Weiss Ratings was the first U.S.-based rating agency to rate the U.S. below AAA. It initiated official coverage in April at the equivalent of BBB and lowered to the equivalent of BBB- in mid-July, just one notch above junk. Back in May 2010, Weiss challenged the three major agencies to downgrade the United States, but hadn’t yet rated the U.S. itself. Weiss is not an NRSRO. And then there’s Dagong, the Chinese rating agency. It initiated coverage with a AA rating in July 2010. It then cut the U.S. to A+ in November and to A last week.
America’s First Debt Crisis
Project Syndicate (Mark Roe, Harvard) | Aug 8
Both Europe and America can learn a lesson hidden in American history, for, lost in the haze of patriotic veneration of America’s founders is the fact that they created a new country during – and largely because of – a crippling debt crisis. Today’s crises, one hopes, could be turned into a similar moment of political creativity. After independence from Britain in 1783, America’s states refused to repay their Revolutionary War debts. Some were unable; others were unwilling. The country as a whole operated as a loose confederation that, like the European Union today, lacked taxing and other authority. It could not solve its financial problems, and eventually those problems – largely recurring defaults – catalyzed the 1787 Philadelphia convention to create a new United States. And then, in 1790-1791, Alexander Hamilton, America’s first treasury secretary, resolved the crisis in one of history’s nation-building successes. Hamilton turned America’s financial wreckage of the 1780’s into prosperity and political coherence in the 1790’s.
Rutgers expert: Credit downgrade will make economy even uglier
Gloucester County Times | Aug 9
John Longo, professor of finance at Rutgers University, said Standard & Poor’s (S&P) first-ever downgrade of U.S. credit from the highest AAA to the next-highest AA+, which caused the Dow Jones to tumble and sent Wall Street into a tizzy, will likely exacerbate an already fragile U.S. economy. Without getting too complicated, here’s why: America sells its debt to investors in the form of Treasury securities. Investors like Treasury securities because for the longest time — at least since the United States first earned its AAA rating in 1917 — they were seen as the most safest, most secure investment there is. By downgrading U.S. credit, S&P shook that belief to its very core. “Everything else looks riskier now,” said Longo. “Every investable asset becomes riskier.” As a result of the additional uncertainty the downgrade has injected into an already uncertain market — whether the uncertainty is real or perceived — Longo said businesses may be less likely to invest in their workforces, causing the unemployment rate to persist at a high level or making it climb even further. If S&P downgrades other U.S.-backed debt, which it’s likely to do, mortgage rates may also go up and pensions and 401Ks may shrink, according to Longo.
The truths behind S&P’s ratings downgrade
The Washington Post | Aug 8
The long-term impact of the downgrade is not yet clear. Yesterday’s market reaction suggested that interest rates could be unaffected as investors shrug off the S&P warning. But over time rates for everything from muncipal bonds to mortgages could be at risk — especially if Congress fails to take more decisive action on the debt. In a few months, the “super-committee” created under the debt ceiling agreement will be tasked with finding another $1.5 trillion to cut from the budget. Failure is not an acceptable outcome, but even success in this short-term goal will not be adequate. More cuts — S&P puts the total savings figure at $4 trillion — must be found, lest the country risk a further downgrade. Adjustments to entitlement programs, including Medicare and Social Security, must be a part of the equation, even in the face of Democratic opposition. New revenue — yes, taxes — must be considered despite Republican vows to resist. The political and market turmoil of the past few weeks will be worth it only if the country’s leaders meet the challenge of coming up with full-fledged solutions.
Buy stocks, sell bonds
Felix Salmon (Reuters) | Aug 8
From a market-dynamics perspective, we’re now in the world of momentum trades and falling knives. This isn’t a repricing of risk based on new information: it’s a trader’s market, which will move in the direction of inflicting the maximum amount of pain on the maximum number of people. I’m not saying that this is an overreaction — the US downgrade is a legitimately momentous event, and will have a large number of unknowable repercussions. A world which highly values predictability and certainty has become significantly less predictable and certain than it was last week. Does that mean that US stocks are worth 20% less than they were at the market highs around 1,370 on the S&P? No — and that’s one reason I’m looking at this move more like a 20%-off-sale than a sign of incipient economic Armageddon.