The arguments are in, and as of this writing it looks like a deal will get done to raise the debt ceiling. The cynical in me still believe the reason it has taken so long is that Congress is allowed to trade on inside information. I would give anything to look at the trades these folks have made in the last few weeks. Apparently they needed it to come down to the wire so that they could actually take advantage of the worst week for the stock market in a year.
But I digress. The biggest issue here has been the credit rating. But not for the reasons people keep talking about. Yes, there are some issues with rising interest rates and free flow of credit.
However, our biggest worry should be the fact that not only is the U.S. dollar the world’s reserve currency, the 10-year Treasury is the global risk-free rate. What happens when the risk-free rate is no longer risk-free? With nearly 20 other countries possessing a AAA credit rating, if the United States gets downgraded, will we still be the risk-free rate?
Why does it matter? All of our pricing models, all of our GLOBAL pricing models are predicated on a risk-free rate that is tied to the U.S. Treasury. What happens to those models when the risk-free rate goes out of the window?
It would create enormous inefficiency in capital markets. Other countries might start using their own rates. Even companies within countries might use different rates and come up with different pricing models. While this could create opportunities for savvy hedge fund managers (who thrive on exploiting inefficiencies in capital markets), it will leave average investors blowing in the wind and subject to the whims of a crazy global market.
While potentially there could be huge gains, the resulting chaos could result in large declines in the market.
I fully believe that it won’t come to this, as I believe the ratings’ agencies are afraid of this exact outcome (along with the rest of us). After all, we should have had our credit downgraded 20 years ago.