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Downgrade to AA+

August 6, 2011

Downgrade to AA+ Ramifications

From Standard and Poors:

“The downgrade reflects our opinion that the fiscal consolidation plan that Congress and the administration recently agreed to falls short of what, in our view, would be necessary to stabilize the government’s medium-term debt dynamics.”

This is huge.

S&P lowered its AAA rating. And, adding insult to injury — S&P even attached a negative outlook to the new AA+ rating. But this decision has now taken place, and now the global system will have to adjust. There are consequences though – and uncertainties.

Every pension fund has a minimum requirement of AAA bonds…and most banks rely on AAA bonds for capital reserves. Insurance companies too. The ENTIRE financial infrastructure is reliant upon AAA bonds for it’s bedrock. US Treasuries were once 75% of all AAA bonds in the world. And, now, 75% of the bedrock has been shaken.

The Discount Interest Rate too could rise – especially if Fitch and/or Moody’s follow suit in the future. Cost to borrow cash, mortgage interest, credit card interest, and most importantly, interest on receivables sold to factoring companies are going to go up. This is because they base their interest rates on the Discount Interest Rate.

FYI: Factoring companies’ work as middlemen. They buy businesses accounts receivables or invoices, pay that business an advance and then reimburse the business for the remainder of the bill, minus a 4% to 5% fee, once the total bill is paid. Factoring companies are EXTREMELY important to the economy. They keep small businesses running smoothly as they maintain cash flow at a constant rate.

Most businesses run on a 2-3% net plus 30, meaning they get 2-3% of the value of the receivable from its customer up front, but have to wait 30 days for the balance. In the interim, they still have to buy supplies, equipment, meet payroll, etc. Factoring companies solve this problem. When the cost of factoring goes up – businesses usually lay off people. This leads to higher unemployment.

The Feds response was, not surprising, business as usual. There will be no change in how the Fed adjusts collateral requirements. There will be no change in their calculations of risked based capital for financial institutions. Okay. But a key question is how central banks outside the US look at US collateral. Will any of them change the haircuts on US paper? Will we see the Bank of Canada, England or others do anything regarding collateral ratios? If so, there will be hell to pay.

In the end, it’s simple logic. When you borrow, as we have done over the past 30 years in order too boost GDP (and gotten less GDP for each $ borrowed each successive year), you get more in the present and less in the future. We are now in the future. It’s simple exponential math. If debt grows faster than GDP, which it has for decades, then there is no way to “grow our way out of it.”

We have debt saturation, not just in the USA but worldwide. Banking systems, households, and governments. There is an ‘insufficient economic engine’ to surmount this mountain (or quicksand) of debt. Repudiations, write-downs, forgiveness and living smaller are the only exit strategy with a chance.

At some point, one is forced to stop the borrowing and pay down the debt. You can’t paper over the simple fact that we pulled forward demand for the past 30 years through debt-financed deficit spending, and that we actually have to pay that back now. When you borrow, you get more in the present for less in the future. Welcome to the future.

Worse yet, the fight is just warming up. Everyone will blame the other, nobody will want to take the hit. According to Bill Gross of PIMCO, one of the largest investment management funds, even if the “super committee” comes up with another $1.5 trillion worth of budget cuts over the next decade, it would only reduce future deficits “at most by 0.5%.

And, did anyone notice Panetta’s propaganda speech about not cutting the military? So the “Super commission’ will work to reduce entitlements rather than gut military spending? Right. Democrat translation: any entitlement cut will include an attempt to increase taxes. The pivot has been made; more taxes to destroy small business and the middle class – all in the name of ‘social justice’ and “shared sacrifice.”

You can dress it up any way you want. The downgrade was a historic event – truly mind-blowing event. S&P, correctly or not, now rates four companies higher than the USA – Microsoft, ADP, Johnson & Johnson, and Exxon-Mobil. But, the USA has something none of those companies have: A money-printing press.

Wouldn’t the printing press treadmill have to be run at infinite speed to print enough infinitely devaluing dollars to pay off the US-denominated debt? Raising the debt ceiling simply will give Bernanke permission to initiate a further expansion of the money supply directly into government coffers. If you scratch an itchy spot until it bleeds, it’s time to stop scratching.

Most Keynesian theories on government stimulus require that consumers and businesses become ‘enthused’ with the piles of government money being circulated around without looking at, or even worse, panic over, the huge debt being piled on the nation. In a normal world, the S&P downgrade should lead to higher interest rates being demanded on U.S. debt. That, in turn, will lead to greater deficits. The poor timing from S&P too came at the most gut wrenching market week in three years; the result: more agitation to global capital market conditions.

The problem with the US economy is our antiquated tax and regulatory structure, plus our debt accumulation. S&P’s job isn’t saving or propping up the market. This downgrade should have happened in 2003. S&P’s first comments and continuing comments is NOT about “deficit reduction” but reduction in the US actual ‘debt obligations.’ I think S&P steered clear of the Fed because they had named the other source of the problem – Washington’s politicians.

S&P said what needed to be done to satisfy them and the results weren’t even close to the mark from Congress. Any blame for adverse effects fall on DC not S&P. Do we really need another commission to realize that we only need political courage to make hard choices? Now the battle begins: Democrats will call for higher taxes and don’t be surprised if Bernanke calls for QE3 ….or more stimulus. Meanwhile, Congress goes on vacation and, Obama is off to Martha’s Vineyard.

The real insult here is that France now has a higher credit rating than the U.S. Sacré bleu!

It’s Mojito time now.

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