Frankly has been so kind as to translate my most recent post. The original French version is here.
“How should one define a catastrophic scenario in a situation such as this?”
There is no panic yet in the American financial markets, but disquiet is spreading. The Dow Jones industrial index fell by 3.3% over the last four trading sessions, half of the decline occurring yesterday.
During the fateful weekend of September 13th and 14th of 2008 the upper echelons of American finance conducted a review of all that could turn sour if they let Lehman Brothers go under.Everything was thought of, except the money market, the short-term capital market, which today has a trading volume of $338 billion. What a pity, as that is what collapsed, causing a blood-letting which it took nearly $1 trillion (a thousand billion dollars) to bring under control.
This is what explains why all eyes are now fixed at this moment on the money market and why everyone who expects to be needing fresh capital in the next three months is scraping the bottom of the barrel for a little ready cash. The first casualty, of course, will be recruitment of staff, as if recent news about the employment market allowed much scope for this! The second casualty: business investment.
Prices of bonds reaching maturity in August have begun to go down over the past few days, but not as much as might have been expected, which is taken by some people to be a further sign that the debate on raising the US debt ceiling is merely a storm in a teacup. But this relatively mild effect at this point is only due to the fact that the dollar is a reserve currency, there being not too many known substitutes for American debt in the financial markets – and in sufficient quantity – to serve as collateral, i.e. security for deposit as a guarantee. A downgrading of the credit rating for US debt will cause a rise in interest rates and a simultaneous depreciation in the value of these debt instruments, which will force those holding them as security to make a ‘margin call’, which means demanding additional guarantees to make up for loss of value. And this will also apply to the infamous Mortgage-Backed Securities, securities backed by mortgages, which in the United States are nowadays almost all issued by Fannie Mae and Freddie Mac, which are Government-Sponsored Entities, which would have to be wound up, moreover, if found to be in default for more than sixty days, which, according to some commentators, is an outcome that the Republicans are secretly hoping for.
A downgrading of the US credit rating will put the base rate up by only 60 basis points, i.e. 0.6%, which represents an increase of $100 billion in the annual cost of servicing the debt, it was stated last night, but this figure is based upon the supposition that the rating agencies will content themselves with lowering the US credit rating from AAA to AA, even though, in view of the slow rate of progress of efforts aimed at reaching a compromise on raising the ceiling of American public debt – the Republicans opposing all increases in taxation and the Democrats giving no ground at all on proposals aimed at dismantling social-security provision – this should now be regarded as an exaggeratedly optimistic hypothesis. In so far as there are internal regulations here and there limiting the holding of debt instruments to those carrying a AAA rating, which would oblige holders of American bonds to find substitutes for them, this is a gamble, to the extent to which the rating of most of the private American debt instruments is linked to federal bonds, the guarantee offered by the state protecting them up to a point. There were, accordingly, reports in the press yesterday that certain foreign bonds, i.e. several Israeli ones and an Egyptian one, would also be subjected to an immediate downgrading because they are 100% guaranteed by the United States.
And these are only the ramifications which have been thought of at this point. In this connection it should be borne in mind how it dawned on people in the autumn of 2008 that it had come to be the case that in the world of finance everything is intertwined with everything else and vice versa. Clearly, the game has only just begun. I shall leave the last word to a businessman who was interviewed in the Wall Street Journal for its Wednesday edition: “We are preparing for a catastrophic scenario. But how should one define a catastrophic scenario in a situation such as this?”