UBS Explains What Happens If The US Is Downgraded Without A Default

Tyler Durden's picture

With increasing chatter that no matter what Congress agrees on, if anything, vis-a-vis the debt ceiling, the preemptive spin has begun, with the first salvo coming out of UBS' George Bory who has released a note "The difference between downgrade and default" which paints a very placid picture of the consequences of the US losing it AAA rating. Coming from a credit strategist, Bory naturally looks at the tightly confined consequences of such an event within the rates space exclusively without any mention of other cross-linked securities. In UBS' view, we would expect i) 10-yr yields rise 20-25bps, ii) a steeper yield curve, especially long end, iii) Treasuries underperform bunds and other highly rated sovereign debt iv) Vol term structure inverts further, v) Corporate spreads tighten, especially at long end, vi) Bank credit quality re-rated lower. Altogether not too bad. The problem is that there are a few trillion in money market related rating triggers which would grind to a halt the repurchase of paper of a sovereign that no longer has the AAA mark, resulting in our opinion in a dramatic crunch in short-term liquidity, and set the stage for a Lehman-like monetary system paralysis. But that is a topic for another day. Since today reality is to be ignored (see "transitory default"), here is why according to UBS America can simply call Moody's and S&P's bluff.

From UBS Daily Corporate Credit Snapshot

“The difference between downgrade & default”

Credit: USA - The difference between downgrade & default. “The budget should be balanced. Public debt should be reduced. The arrogance of officialdom should be tempered and assistance to foreign lands should be curtailed, lest Rome become bankrupt.” – Cicero

An actual default would occur if the US government misses one of its contractually obligated interest or principal payments. We, along with many other market participants, view the risk of an actual default as quite low. Indeed, even Congress recognizes the risk of default and appears to have a fallback strategy to allow the President to raise the debt ceiling to avoid a default in the event a broader deal fails to materialize. However, the sanctity of the US’s triple-A credit rating does not appear to be held in the same regard.

Two months ago, Moody’s fired a warning shot across the bow of the US’s triple-A credit rating when they changed their outlook to “ratings under review for possible downgrade” from “stable.” At the time they cited the looming debt ceiling debate as a possible stumbling block for the country’s rating. Last week Moody’s clarified and strengthened their position while S&P weighed in by placing the ratings on “CreditWatch with negative implications.” S&P went as far as to say there’s at least a one-in-two chance they will downgrade the US into the double-A category within the next 90 days if “Congress and the Administration have not achieved a credible solution to the rising U.S. government debt burden.” S&P quantified an agreement in the realm of “about $4 trillion” which could be “enacted and maintained throughout the decade” as a core achievement which would be key to affirming the AAA long term and A-1+ short term ratings of the U.S.

1) A long-term, credible deal which puts the US’s debt/deficit ratios onto a downward sloping trajectory; and

2) A change to the debt limit legislation mechanism. Threats of periodic payment interruptions are not a characteristic of an Aaa/AAA credit.

Based on recent comments out of Washington it doesn't appear as though either of those conditions are going to be met, thus raising the probability of a rating downgrade.

Do ratings matter? They do for some and not for others. S&P suggested they “may lower the long-term rating and affirm the short-term rating if they conclude that future adjustments to the debt ceiling are likely to be the subject of political maneuvering to the extent that questions persist about Congress's and the Administration’s willingness and ability to timely honor the U.S.'s scheduled debt obligations.” S&P's solution of downgrading the US’s long-term rating while affirming its short-term rating may provide some relief to investors constrained by rating guidelines.

If the US were avoid default, but have its long-term rating cut to ‘double-A’ while its short-term rating is affirmed at A-1+, then the impact on the fixed income market would be material but not catastrophic. We estimate that US Treasury 10-year yields may rise by as much as 20-25bp while the shape of the interest rate curve would likely steepen, particularly towards the long end of the curve. US Treasuries would also likely underperform the government debt of other highly rated countries, namely German Bunds. The term structure of volatility would likely invert further as the value of short expiries rises compared to long expiries, reflecting these near-term uncertainties. Corporate credit spreads may tighten as the perceived credit-worthiness of corporate America is viewed as improving while the government deteriorates. This is particularly true at the long end of bond curves where marginal changes in credit worthiness are felt most acutely. Finally, Financials, specifically Banks, are likely to suffer a re-rating by credit markets as a bank’s credit quality is rarely viewed better than its home country.

In short, and in quoting Julian of Norwich, "...All shall be well, and all shall be well, and all manner of thing shall be well" a saying, allegedly straight from god, which has become the motto of a crumbling centrally planned world.