PIMCO Sees UK Rating Downgrade Probability At 80%, Gilts Higher By 100 Bps

The end of QE will be a big problem in the US. Yet what happens in the UK, where the BOE is openly monetizing, once their free liquidity ends, could be a watershed event. Couple this with the likelihood of a downgrade, and the UK's fiscal and monetary future in 2010 is looking quite shaky. Today PIMCO's Scott Mather told Dow Jones his expectation for a rating downgrade of the island nation: "It's just a question of when on the current trajectory, not if. Based on what we know today about the debt trajectory and about the inability to adjust that, I think it's greater than a 50% likelihood for sure. Call it more like 80%." And according to Mather, rates on gilts will shoot up by 100 bps once the bond-buying program ends. It is amusing that the fiscal health of the developed world now hinges on the amount of ink cartridge accessible by the two main central banks.

PIMCO, which has recently made waves after Paul McCulley said he is a strong to quite strong buyer of pretty much nothing, has become quite the bond bear. More from Mather via Dow Jones:

"Common sense would tell you that if you had a buyer in the market place which was taking the majority of the sector repeatedly... and then they disappeared, ...you would expect a reprising, and it could be quite significant," he said in a telephone interview. "The estimates vary. They're really all over the map, but it could be 50 basis points, it could be 100 basis points, in that range."

It is unfortunate for the Brits, that unlike their transatlantic descendants, the pound does not share quite the "reserve" reputation of the greenback, implying that their ability to print their way out of the crisis is much more limited.

And speaking of Britain, an interesting line of thought brought by Mark Kleinman's SkyNews blog highlights that even as City bankers are leaving in droves for Switzerland, none other than Goldman Sachs has found a loophole to make sure its employees do not suffer the recently adopted increased banker bonus tax.

Goldman Sachs, the US investment bank, is moving towards a decision that rather than passing the cost of the tax onto employees by absorbing it within the year-end bonus pool (which would automatically mean paying out less money to staff), it will instead gross up its bonus pool so that the bank pays the cost of the tax itself. So, for example (and these numbers are for illustrative purposes only), if Goldman is liable for a £400m tax bill on a UK bonus pool of £1bn, the bank will simply allocate £1.4bn rather than £1bn to bonuses for UK-based staff.


On the face of it, that would mean that Goldman bankers based in London will not feel the impact of the bonus tax when bonuses are awarded over the next few weeks - which would be a potentially controversial decision given that Goldman is viewed in political circles both in Britain and in the US as the flag-bearer for Wall Street's racy bonus culture.


Institutions can choose between bearing the cost of it themselves (which could mean shareholders missing out in the form of lower dividends if the money comes out of the dividend pot), or passing it on to their employees (either by singling out UK-based staff or spreading it across the global employee base in the form of lower bonuses).


Of course, they could also choose a combination of the two approaches - something that I expect Barclays to do in the coming weeks (see my note of a couple of weeks ago). Or they could simply slash their bonuses for one year - which looks like it is unlikely to happen on an industry-wide basis, meaning that the Treasury will reap many times the £550m it had bargained for from the tax.


Goldman is the first of the major investment banks operating in the City to decide that it will bear the full cost of the tax itself.


I don't yet have concrete guidance about the size of the Goldman tax bill (it's still being worked out by the bank), but given the Wall Street titan's profitability during the 2009 financial year and the amount of money it has already set aside for staff compensation, it's unthinkable that it will be less than several hundred million pounds.

The take home here is that being a defacto monopolist in every market one participates in provides huge economies of scale...and paydays. Who knew... And even as other, less "fortunate" banks are unable to bear the full tax cost are forced out, Goldman will once again benefit by becoming a dominant player in yet another critical market. Well played oh acolytes of the lord.