For those confused by the cornucopia of assorted debt ceiling "plans" out in circulation, Citi's Amitabh Arora has released the definitive guide for what plan does what in terms of proposed deficit reduction, probability of passage of the Congress, Senate and the President, and likely outcome to the US rating. As table 1 below shows, UBS' prescient call from last Thursday that a US downgrade is inevitable, was spot on. It also explains why the entire sellside industry, and media, have been in damage control over what now appears to be an inevitable AA rating of the world's reserve currency. Alas, just like with Lehman, nobody really has any idea what will happen to capital markets once the Poor Standards or Moody's headline of a AA cut hits the tape: one thing is certain - there are trillions in US invested money market funds, structured finance debt and munis that have rating mandates and demand a super secure (AAA) threshold, and especially an A-1+ short-term rating. Should there be a massive flow out of these securities and into other asset classes, the outcome is absolutely unpredictable. More importantly, Citi touches on a topic that has not seen prominent mention anywhere else: namely the acceleration of the GSEs status from conservatorship to receivership should there be no prompt resolution on the debt ceiling. For agency paper holders this may be a topic that merits much more diligence.
So without further ado, here is Arora's summary of how he sees the world:
- We expect little chance of a large debt reduction package being passed by August 2nd. A package with the least controversial cuts (~$1.5 trillion) is the most likely outcome of the debt ceiling negotiations
- We see a 50% chance of a rating downgrade to AA.
- We see little forced selling from the main holders – central banks, commercial banks and money managers - of Treasury, agency MBS and agency debt. Accordingly, we see little market impact.
- A ratings downgrade could significantly widen spreads in the government guaranteed student loan market (FFELP program) since investors in this sector require a AAA rating. The other securitized product markets should be relatively unaffected with exception of a few fully defeased deals (CMBS, CLO equity repacks and CLNs), which are invested in Treasuries.
- Long-term municipal debt should be affected more by the spending cuts built in the package than by the ratings downgrade. Some short-term municipal instruments could be affected if the banks providing liquidity backstops are downgraded as well.
Here is the tearsheet table everyone has been waiting for:
Summarizing these various plans:
- Extend (and Re-Visit) — Given the late date and lack of clear consensus, there is an increased probability that a temporary fix will take place. This could take the form of a very small increase ($100-250 billion) which would merely serve as a stop-gap to allow current negotiations to continue. This is a likely scenario only if it appears that a meaningfully break-through is at hand, but the time to get it through the political process would not meet the default deadline. This could also take the form of a larger increase ($1 trillion) that would allow negotiations to continue into 2012. This seems like a less likely outcome. The short-term version would likely avert a sovereign downgrade (assuming a large deal followed) while the longer-term version would likely result in a downgrade to double-A.
- McConnell Plan — This is the plan that no one really likes, but is politically expedient. It solves the issue of raising the debt ceiling, gives politicians cover to not raise the debt ceiling and accomplishes very little on the long-term fiscal issue. The plan would raise the debt ceiling by a total of $2.5 trillion over two years unless a two-thirds majority revoked the increase. This is $300 billion cut relative to baseline forecasts that would need to be resolved by the President through spending cuts and with tax increases. It seems very likely this would result in a downgrade of the US sovereign to double-A.
- ‘Gang of Six’ Plan — This is the most plausible grand plan available. It would reduce the deficit by just under $4 trillion over 10 years — likely enough to delay a downgrade of the US sovereign. Specific details of the plan are thin, but the plan appears to relay on about 75% on spending cuts and 25% on increased revenues. The trick it has is that it fixes the AMT, which allows it to increase taxes relative to the plausible baseline scenario while cutting taxes relative to the CBO baseline scenario. This trick gives it some hope to get through the Republican House that has pledged no new taxes. However, the tax increases will include reductions in mortgage interest and charitable contribution deductions that make that hope very low.
- Cut, Cap and Balance — This plan requires that the deficit be cut in half next year, federal spending to be limited to 18% of GDP and for Congress to pass a Balance Budget amendment to the Constitution. Given the drastic cuts involved in the plan it would certainly allow the United States’ triple-A sovereign rating to be maintained. This plan passed the House of Representatives on Wednesday, but is very unlikely to pass the Senate and the President has stated that he will veto this bill if it is able to pass the Senate.
- Default — Perhaps even more unlikely than the Cut, Cap and Balance is that no plan at all is reached prior to either a default on US Treasuries or a default on other US spending obligations. Obviously this event would lead to a downgrade of the US sovereign risk below triple-A. The rating agencies have differed on their guidance with Moody’s suggesting ‘Aa’ based on expectation of it being a shortlived event, S&P suggesting ‘SD’ or selective default and Fitch suggesting ‘B+’.
The downgrade is coming:
Given the likelihoods of each of these plans (or ones that resemble them) we think that the odds of a US sovereign rating downgrade are relatively high. Once again we want to emphasize that the likely outcome is based on long-term fiscal issues, not a debt ceiling breach. While we see very little chance of a default and massive US sovereign downgrade - we see a better then 50% chance that thedeal to increase the debt ceiling is not strong enough to prevent a downgrade to double-A in 2011.
Next, Amitabh looks at what the various UST holders will do in an event of a downgrade. Naturally, this is a very biased perspective:
We will split the above categories into five groups to discuss likelihood of reaction to a downgrade to double-A.
Household, Corporate & Government — Domestic households, corporations and government entities (including the Fed) are unlikely to sell a meaningful amount of Treasuries on a downgrade to double-A Most of these entities will have very US-centric portfolios and the lack of alternative US triple-A securities will likely result in investors maintaining Treasury holdings.
Financial Institutions — US Banking and insurance institutions are also unlikely to want to sell due to a downgrade to double-A. There is also no risk weighting impact of this type of a downgrade under any of the Basel frameworks. A downgrade into the single-A category could potential motivate sales from these institutions based on Base II/III. However, this is extremely unlikely in the nearterm absent a technical default.
Money Managers — The majority of money managers will not sell due to a downgrade to double-A Keep in mind that most are index benchmarked and the change in their benchmark would mostly mirror the change in their assets, absent an overweight to the assets that are downgraded.
Money Markets — Under a downgrade scenario to double-A it is expected that the US would continue to hold a short-term ‘A-1+’ rating which would mean that US Treasuries remain first tier securities. Therefore, we would expect that there would be limited selling of short-term Treasuries by money market funds. [ZH: we disagree completely with this superficial analysis]
Foreign Official — Central Bank and Sovereign Wealth Funds are likely to modestly sell and modestly reduce future purchases of Treasuries. We think that very few would be forced sellers at the double-A level — although some potentially could be. However, we think that this would forever change the view of US Treasuries as a riskless asset. In practice, this type of an action would likely slightly accelerate the diversification out of US Treasuries into other assets that have been under way for decades.
Other Foreign — We expect that there would be few forced sellers, but more sellers by choice in this category. It is more likely that these investors are in out of benchmark investments and these investors are certainly non US centric. While foreign financial institutions may have many of these securities matched versus US dollar liabilities, many investors are likely to look at other triple-A assets worldwide as a substitute.
And while all of the above is largely part of conventional wisdom, what isn't is the concern what a "no deal" outcome would have for the GSEs. In short: ugly.
Failure to reach a debt-ceiling agreement by August 2nd is a more threatening scenario for Agency MBS than a downgrade. The possible ‘no-agreement’ outcome introduces a few low-probability yet significant tail risks to the Agency MBS market:
- Triggering of Receivership — If the Treasury is not able to transfer payments to the GSEs under the Treasury Preferred Stock Agreement, receivership of Fannie Mae and Freddie Mac will likely be triggered. However, a debt-ceiling impasse would need to last until at least September 30th for this outcome to become a real possibility.
- Potential for Large-Scale Selling — If no debt ceiling agreement is reached, the US Treasury may accelerate sales of MBS in order to create room underneath the debt ceiling. If receivership is triggered, the GSEs will likely shed assets more quickly than the currently mandated 10% per year.
Triggering of Receivership
In the event there is no agreement reached on the debt-ceiling, the US Treasury will need to begin prioritizing its obligations. Such obligations include interest on the national debt, tax refunds, military salaries, Social Security and Medicare benefits, along with their obligation to Fannie Mae and Freddie Mac under the Treasury Preferred stock agreement. If the Treasury fails to provide funds to Fannie Mae and Freddie Mac through the stock purchase agreement, the organizations will likely be placed into receivership. In their 10Q, Fannie Mae notes receivership as a possibility if the government exceeds its authorized debt ceiling:
"Because of the credit-related expenses we expect to incur on our legacy book of business and our dividend obligation to Treasury, we will continue to need funding from Treasury to avoid triggering FHFA's obligation [to initiate receivership].
Although Treasury committed to providing us funds in accordance with the terms of the senior preferred stock purchase agreement, Treasury may not be able to make funds available to us within the required 60 days if providing the funds would cause the government to exceed its authorized debt ceiling.”
Fannie Mae would need to receive a payment from the US Treasury by around September 30th, 2011 in order to not be placed into receivership; the Treasury will very likely be able to fulfill this obligation. Even if an agreement is not reached by August 2nd, the US Treasury would still have two months to send payment to Fannie Mae without triggering receivership. In our view, the Treasury would choose to sell MBS and send the proceeds to Fannie Mae and Freddie Mac over missing the capital injection. Over the last year, payments to Fannie Mae and Freddie Mac have not exceeded $10billion per quarter (Figure 8).
Potential for Large-Scale Sales
If no agreement is reached regarding the debt ceiling, the potential for large-scale selling of Agency MBS arises from two sources:
- US Treasury — In order to create room under the debt ceiling, the US Treasury may decide to accelerate sales of Agency MBS. At the end of June, Treasury holdings of Agency MBS totaled roughly $95 billion.
- Fannie Mae/Freddie Mac — If the Treasury fails to fulfill its obligation under the Treasury Preferred stock purchase program, the GSEs will be placed into receivership and assets will be liquidated. At the end of May, Fannie Mae and Freddie Mac owned roughly $550 billion of Agency MBS combined.
Another question is what happens to trillions in structured credit which has a AAA floor:
Moody’s states that its A2 rating is a likely sovereign debt floor in order for a structured rating to qualify for triple-A. Below this rating, the probability of extreme loss scenarios would become more significant and inconsistent with triple-A structured ratings.
We hope to have much more data on the key structured finance variable shortly.
Next up, parsing the downgrade impact on munis, which is especially relevant to portfolios with rating mandates:
As rating agencies move closer to downgrading US debt, there is increasing (and justifiable) concern among municipal market participants regarding the potential impact on their market. In our view, we still believe that the possibility for a technical default due to a failure to increase the debt ceiling is remote. But then, a few months ago, we didn’t expect the political wrangling on the debt ceiling to come to such an impasse. Will we witness an instance of cutting off one’s own nose to spite one’s face? It remains to be seen.
There is a difference in the language by S&P and Moody’s regarding the conditions leading to a downgrade of US debt but in our view, a downgrade by both rating agencies is likely in the absence of a major deal on deficit reduction.
The possibility of a US debt downgrade will affect some municipal sectors more than others. Moody’s is reviewing the ratings of all directly linked munis (7,000 ratings/$130 billion) while indirectly linked munis may also be placed on review for possible downgrade. They have outlined the sectors that will be more affected, versus those that will be less affected, and we largely agree with their analysis
Directly Affected Sectors
Healthcare bonds, housing revenue bonds, pre-refunded bonds, federal highway grant anticipation bonds and GOs of states that are more closely linked to the federal government, among others.
Indirectly Affected Sectors
Higher education and other non-profit sector bonds, GOs of states that are less closely linked to the federal government and local GOs that are vulnerable to economic weakness but less reliant on Federal transfers, among others.
Revenue bonds that have standalone ratings and are not reliant on the US for support, highly rated taxable university bonds, VRDNs with unconditional support backed by bank LOCs and tobacco MSA bonds, among others.
Portfolios that invest only in triple-A rated securities may seem limited, as the mandate is not directly visible, but rating restrictions can adversely affect muni holdings. Figure 14 shows the municipal holdings as of Q1 2011, and, below, we discuss the impact of a possible downgrade on the some of the larger institutional portfolios.
Mutual Funds: Most funds limit concentration risk along the rating scale of investment-grade securities. For instance, a high-grade tax-exempt portfolio might hold 20% of its assets in triple-A securities, 40% in double-A-plus securities and 40% in double-A securities. We note, however, that portfolio mandates can change. Still, Treasuries would be the benchmark, and deployment out of taxexempts due to the correlated downgrade should be muted.
Commercial Banks/Insurance Companies: Holdings are affected by risk weight-based capital requirements in Basel II and III. If risk weights go up, CAR goes down (CAR6 = Equity Capital/Risk-Weighted Assets). Commercial banks typically hold high-quality municipals, and, thus, the impact on risk weights should be low but not insignificant.
Tax-Exempt Money Market Funds: SEC Rule 2a-7 requires money market funds to invest 97% of their portfolio in Tier 1 securities. Typically, these are securities with a short-term rating of VMIG1/SP1/F1 or better but other clarifications may apply.
Depending on the size and extent of the downgraded, there could be some spillover affect of rendering a sizeable amount of TOBs ineligible on the long-end of the market.
Closed End Funds: Leveraged tax-exempt closed end funds, like other closed end funds, typically face risk from an inverted yield curve and asset coverage requirements. Currently the leverage ratios aren’t comparable to the levels seen in 2008 and we aren’t predicting an inversion of the yield curve. Thus, we expect the impact on closed end funds, which have duration of 10YRS and under, to be somewhat muted.
Lastly, a quick look at funding markets:
The standardized supervisory haircuts according to Basel III are show in Figure 17. But, in financing transactions, municipals require a higher haircut versus comparable corporate securities (Figure 18) because corporates are more widely accepted as collateral in the funding markets and are perceived to be a lot more liquid.
While the haircuts are unlikely to increase across the credit spectrum, muni financing transactions could be affected with regard to downgrade triggers, margin maintenance and substitution clauses. Lenders are typically required to substitute loaned securities with UST or cash in case the security is downgraded below BBB- /Baa3. In the event of a disruptive downgrade, we expect regulators to come out with guidance fairly quickly, much like the ECB did at the start of the Euro peripheral crisis.
Bottom line: the with the above just a sampling of the broad across the spectrum impacts, to say that anyone has any idea what will happen should the US go from AAA to AA is pure lunacy. And for anyone who plans on buying any rate exposed instruments (or, of course, stocks) on that "catalyst" we have two words: good luck.