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.