Report from Leen’s Lodge
August 4, 2011
“Indeed, it has been said that democracy is the worst form of government except all those other forms that have been tried from time to time.” Winston Churchill in the House of Commons, November 11, 1947
After a brutal fight, the debt ceiling has been extended. From our perspective, there is some good news in this outcome, notwithstanding the vitriolic and distasteful exchanges that occurred in reaching this final result.
In the end, everyone conceded in order to avoid default. The most critical outcome of the debt-ceiling debate was to not participate in default. The United States of America affirmed its agreement to pay what it owes in a timely fashion. Even though the politicians of our country waited until the eleventh hour, fifty-ninth minute, and fifty-ninth second, they came together because the prospect of default was worse than the terms that were being negotiated in this fierce political exchange.
The left wanted to raise taxes, while the right wanted to rein in spending. Fortunately, neither side got 100% of its way. The White House said it would not accept such a package, but in the end agreed to it.
The paramount issue was the creditworthiness of the United States. This political process that we all criticize – however messy and ugly it is – ended in the right outcome. The United States of America has the absolute ability in economic and financial terms to meet its payments in a timely way, and will do so completely.
The first take-away from this debate is that there will be no default. One can observe this in the very substantial move in Treasury obligations. The 10-year Treasury yield is approximately 60 basis points lower than it was right in the heat of battle. The 30-year US Treasury bond trades close to 3 3/4% or a little under. The yield curve in Treasuries is flattening. Why? Short covering from global shorts of US Treasury obligations is actively buying in and closing and neutralizing the positions. We have a rally in US Treasuries because there will be no default. Any default risk premium in Treasuries is rapidly extracted.
The second take-away concerns the AAA credit rating of the United States. If the markets believe the United States of America’s credit rating is a deteriorating event, then why would the prices of Treasuries be rising and their yields falling? The fact is the markets do not believe this. The credibility of the rating agencies is now diminished. These rating agencies once rated collateralized debt obligations (CDOs) as AAA and rated the municipal bond insurers as AAA. The same rating agencies now threaten to withdraw the AAA rating from the United States of America.
Of course, these rating agencies will never say they have moved from one extreme to another in order to restore their credibility. Maybe they think that threatening the creditworthiness of the United States in terms of rating will restore their bona fides. It is interesting to compare the behavior of the rating agencies as well. Standard and Poors is out in front of the threat to downgrade the United States. Moodys is less so inclined. Fitch is also less aggressive, warning but recognizing that the US can certainly pay its bills if it wills itself to do so. Independent rater Sean Egan has lowered his rating of the United States. Sean examines the implications of political shifts as part of his process. That is to his credit. The mainstream rating agencies of S&P, Moodys, and Fitch do not examine the political process.
Here is something to consider: should there be a separate rating activity that discusses the role of political will in the process? If there were such a thing, would it speak highly of the United States because of the debt-ceiling outcome, or would it criticize the United States because of the ugliness and uncertainty of the process? This makes for an interesting debate. At the present time, there is no political rating system on top of the economic and financial rating system.
On the note of political will, there is an interesting question to be asked about the functions of democracy and how it deals with austerity budgets. We have witnessed the budget fight firsthand here in the US. Back off for a second and look at what happened in Italy. Berlusconi reached a deal with his competitor; they acted together in a coalition and passed an austerity budget in a matter of days. One could say that the political process worked well in Italy. In Greece, amidst a million citizens protesting in the streets, Papandreou made a deal with his opposition, formed a coalition, and passed an austerity budget. One could say democracy worked in Greece, as well.
However, there is a difference between evaluating the financial and economic capacity to pay and examining the political mechanism and will. Unlike the Europeans, in the United States we do not have a parliamentary system. The mechanism by which you reach an agreement in Europe can be the threat of the failure of a vote of confidence in Parliament and a new election that can be called. In the US, that system would not work. We have our own controversial and vicious debates. The Congress of the United States and White House were able to find a solution to avoid default. That’s a good thing.
I am here at Leen’s Lodge. Here is a view from the outside deck. http://www.cumber.com/content/commentary/lodge.jpg. Nature provides respite, with the view of a beaver house from Tomah Stream, Passamaquoddy Reservation land, near Grand Lake Stream, Maine. http://www.cumber.com/content/commentary/beaver_house.jpg.
We are scheduled with Bloomberg Radio and will be on Bloomberg TV at 6:30am on Friday. Media coverage of our event is the largest it has ever been. In addition to Bloomberg Radio and Bloomberg TV, we have Dow Jones, WSJ.com, Barrons, and NPR. Many attendees also have market letters for websites, so reports about viewpoints of the various participants will be available to everyone who is interested. The stock market selloff and Bank of New York fee is the hot topic tonight. Opinions abound. We will have more tomorrow on Bloomberg.
David R. Kotok, Chairman and Chief Investment Officer