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Home Publications Blogs Beat the Press If S&P's Downgrade Was So Important to Financial Markets, Why Did Bond Prices Soar?

If S&P's Downgrade Was So Important to Financial Markets, Why Did Bond Prices Soar?

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Thursday, 18 August 2011 07:07

It's pretty bad when our nation's leading newspaper can't tell which way is up. The NYT told readers today that:

"members of Congress are investigating why S.& P. removed the nation’s AAA rating, which is highly important to financial markets."

If the triple A rating is so important to financial markets, then why did bond prices soar in the first trading day after the downgrade? The downgrade should have meant U.S. government debt is viewed as more risky. This means that government bonds should command a higher risk premium and therefore sell for a lower price. The exact opposite happened.

Of course the stock market did plummet, but that is another obvious explanation: the fear that the debt crisis in Italy and Spain could lead to the collapse of the euro and another Lehman-type financial freeze-up. This explanation fits the pattern of movements in financial markets. The idea that the markets panicked over the downgrade doesn't.

The article also discusses the inherent conflict of interest that results from having the issuer pay the credit rating agency for its rating. It would have been worth mentioning a provision in the Dodd-Frank bill introduced by Senator Franken which would eliminate this conflict. The Franken amendment would have the SEC pick the rating agency.

Representative Frank put in a provision in the conference report that delayed the implementation of the Franken amendment, pending the outcome of an SEC study of the issue.

Comments (6)Add Comment
Bond Prices Driven by IQ
written by izzatzo, August 18, 2011 8:35
Exactly. Any economist knows just as bond prices are inversely related to interest rates economic IQ is inversely related to content appearing in mainstream media.

Stupid liberals.
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written by skeptonomist, August 18, 2011 9:07
It is hard to see how having the SEC pick ratings agencies in a presumably random process would have avoided the problem with bundled mortgages. If these things had somehow been given realistic ratings, it might well have choked off their issuance from the beginning, and the agencies would have lost a huge revenue source. The agencies would not want to do that, regardless of inter-agency competition (which could hardly be fierce anyway, given how few there are).

In this particular case, a key element of the problem was CDS's, which were interpreted as giving safety to individual securities while the systemic risk was overlooked. Was it really the responsibility of the agencies to evaluate the systemic risk? That responsibility lies with those who approved CDS's in the first place, or more broadly with a system which assumes that anything that markets do is good until proven otherwise. And although CDS's have proven to be a systemic risk they have still not even been regulated significantly.

By the way, the systemic risk appears only when CDS's reach a certain prevalence - before that they do convey safety to individual issues. The agencies would have had to identify that point.
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written by Jay, August 18, 2011 9:23
This reminds me of the old jokes about not talking bad about the President or you might get audited. S&P really asked for this one. Hopefully, Justice gets the resources to actually conduct a real investigation.
US Government Debt
written by shrpknvs, August 18, 2011 12:18
Dean,

Would you be so kind to please briefly comment or provide further elaborate on the the top holders of US debt in one of your future posts?

According to the below link, out of $12.044 trillion China is the largest foreign holder with $895.6 billion, way below "Other Investors/Savings Bonds" with $1.458 trillion and the FED with $5.351 trillion. These numbers are, of course, out of date, but my guess is that the relative portions of holders of the debt have not changed significantly. Thank you for you posts.

http://www.cnbc.com/id/29880401/The_Biggest_Holders_of_US_Government_Debt?slide=16

Solidarity, peace and joy,
shrpknvs
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written by shrpknvs, August 18, 2011 12:20
*or to further elaborate...
...
written by Ian, August 18, 2011 8:56
I'm not Deanm but I can tell you that the debt now is about $15T, but $5T is intergovernmental debt. There is almost no interest liability on that portion. China holds about 10% of the rest. The average interest rate is about 2%. Therefore, the interest liability is about $300B. The debt size is not an immediate problem, despite what you read.

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About Beat the Press

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.

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