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Saturday, July 30, 2011

What Is The Fair Credit Rating For Treasury Debt?

Due to an impasse in Congress, there is a risk of technical default on Treasury debt. "Technical default" means "payments not made of time".

Even a technical default can be partially corrected. For example, bondholders can be given extra accrued interest when a budget deal is reached. That would be "fair".

Due to the political risk of a technical default, Treasury debt may be downgraded. However, that's a smokescreen that obscures the true issue.

The credit rating agencies only exists because of the government. There's a law that says that certain businesses may only invest in high-rated debt. The three biggest credit rating agencies (S&P, Moody's, Fitch) are effectively given a monopoly/oligopoly by the government.

The biggest credit rating agencies have a lucrative business only because of government. Do you expect them to disobey their master? Of course Treasury debt has a great rating!

There's a big fallacy for the Treasury debt credit rating. The credit rating agencies are only measuring "risk of technical default", the risk you won't get dividends and payments on time. The real risk is "default by inflation", a risk that the credit rating agencies completely ignore.

The Federal Reserve has a credit monopoly. They fix interest rates artificially low. The Federal Reserve directly fixes Treasury interest rates. The Federal Reserve indirectly fixes private debt rates, because banks can borrow at the Fed Funds Rate (0.25%) and buy other bonds. Due to negative real interest rates, almost every bond investment is a lousy deal. A corporate bond interest rate of 5%-8% is insufficient compensation for real inflation.

The US government is the issuer for dollars. However, the US government has delegated money-creation power to the Federal Reserve. The US government can always create more bonds and more paper to keep refinancing its debts.

As long as US government debt is in dollars, a technical default can never occur. The only way a technical default can occur is if Congress can't agree on a budget.

The real Treasury default is by inflation. Treasury yields are 0%-4.5%, and real inflation is 20%-30% or more. That is a default rate of 1%-2%+ per month.

Banks don't mind inflation. Banks like inflation, because their underwater assets become valuable. Banks profit from leverage, making the inflation rate irrelevant.

Suppose a bank owns a $1M mortgage on a house worth $200k. That's $800k underwater. Suppose there is 100% inflation. Now, there's a $1M mortgage on a house worth $400k. That's only $600k underwater. If there's sufficient inflation, the bank is bailed out and the house is worth more than the mortgage. Therefore, banks like inflation. If there's high inflation, there's practically no risk in lending to people, because the collateral rises in value even if your foreclose. High inflation makes it easy to repay loans with devalued dollars.

Suppose a bank borrows from the Federal Reserve at 0.25% and buys Treasury debt yielding 1.25%. With 100x leverage, that's a profit rate of 100%. It makes no difference if inflation is 30%.

As an individual, you'd be an idiot to buy Treasury debt. You return is much less than inflation. Individuals only are allowed unleveraged Treasury debt investments. (Even if you did try to create your own investment fund, you wouldn't be allowed as high leverage as "too big to fail" banks. The Primary Dealers will always be able to borrow more cheaply than everyone else.)

There is a continuous default on Treasury debt due to inflation. This is a guaranteed loss of 1%-2%+ per month. Taking into account the guaranteed default via inflation, the proper credit rating for Treasury debt is not AAA; it's F.

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