The Irony of the S&P Downgrade

At Columbia last year I took a class called “Modern Political Economy” from Ray Horton. One of Horton’s favorite things to say was that sooner or later, if the U.S. didn’t solve its debt issues through the political process, the world’s capitalists would do it for us — as in the debt markets would punish us for our profligate ways, and raise the cost of borrowing.


And yet, here we are: a ratings agency has downgraded our credit for the first time ever. But on the first day of trading, rather than going up, rates on our government debt fell to near record lows as money poured out of riskier assets in a flight for safety. When the markets closed last Friday, and the U.S. still had a AAA rating from S&P, the yield on the 10-year Treasury was 2.55%. It ended Monday down to 2.34%. The same thing happened during the stock market sell-off in the fall of 2008, when the rate on the 10-year Treasury went from around 4% to less than 2.5%. U.S. government debt is still the safest, most liquid market in the world. The S&P downgrade doesn’t change that. In fact, the immediate effect has been to make it safer. How strange.

Also worth noting, as Nate Silver pointed out on Twitter Monday afternoon, is that prices on U.S. credit default swaps barely budged on Monday, up just .3%. A credit default swap is essentially an insurance contract to protect against a company or a nation defaulting on its debt. If the market truly believed S&P’s downgrade was deserved, prices for CDS contracts on U.S. debt would have gone up significantly yesterday.

Finally, a quote in a Reuters story from a credit analyst caught my eye:

“The CDS market has been pricing the U.S. credit as an AA credit for some time,” said Otis Casey, director of credit research at Markit in New York.

U.S. CDS had traded below 2 basis points until late 2007, when concerns about the need for government spending to bail out financial institutions began. Fears over the rising debt burdens of governments have increased since this time.

“There is not a concept anymore of a risk-free rate,” Casey added.

I find this silly. U.S. T-bonds and bills have been a proxy for the risk-free rate for decades. Without a risk-free rate, modern finance essentially falls apart, since it is the building block of most financial models. People use it for determining everything from the value of a company, to the price of an option or a bond.

Of course, the very concept of a risk-free rate has always been relative. It assumes a zero chance of default. If you want to get technical, there isn’t a zero chance of anything really. But still, as the market proved on Monday, U.S. treasuries are still the least risky place to put your money in the whole world. So there you go: AA is the new AAA. Proceed.


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  1. Joshua Northey says:

    I find:

    “I find this silly. U.S. T-bonds and bills have been a proxy for the risk-free rate for decades. ”


    “Of course, the very concept of a risk-free rate has always been relative. It assumes a zero chance of default. If you want to get technical, there isn’t a zero chance of anything really.”

    illuminating. Pointing out the risk is non-zero is not just being technical, it is being honest and realistic. The quants ignoring/rounding off negative outcome low probability events is part of what got us into this mess in the first place.

    Particularly when you are talking about things like insurance contracts pretending that “some number very close to zero” is EQUAL to “zero” is the height of foolishness and a good way to ensure you eventually lose everything.

    Why don’t we make an infinite series of bets. You can have a 99.9% chance of winning. If you win I give you $10, If I win you give me $1,000,000. You have to make a minimum of one bet a day. Come on the bet is practically “risk-free”.

    On another note just because people cannot think of a better place to hide their money than gold and treasuries does not mean those are good or safe investments.

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    • Ray says:

      Hidden due to low comment rating. Click here to see.

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      • Ed Kay says:


        Hmm. At the risk of making the obvious apparent, seems you made Mr. Northey’s point for him. Guess it’s you who should try again.

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      • Joshua Northey says:

        You are missing the point Ray…

        The point is that you are not able to differentiate between games rigged in my favor and games rigged in your favor and fair games if you start saying, “well that is so low it might as well be zero”.

        There is a colossal difference between 99.99 and 99.99999 as you and other numerate people know. But that difference is NOT intuitively obvious to most people. 1/100th and 1/100,000th are just both tiny tiny numbers. A lot of people psychologically treat them as the same, but such small numbers make huge differences when dealing with insurance contracts and the like.

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      • Gary L. says:

        “but such small numbers make huge differences when dealing with insurance contracts and the like”

        Or really anything where you have a massive volume of transactions.

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      • Ray says:

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      • Steevn says:

        I agree with you Ray, though I may be the only one. The example was fine for illustrating a principle, but I too would like to see an actual, real world example of the number problem that fooled the best and brightest on Wall Street. I don’t doubt there are such examples, I just want to see exactly what they were dealing with in 2008, now that we’re clear on the basic principle of it.

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  2. Clancy says:

    The way someone explained it to me was: It’s not that the chance of a US default was zero, but that the only circumstances that would make a US default likely were so horrific that it’s not even worth thinking about. If the financial situation were so bad that T-bills became worthless, then everything else will have become worthless long before. Everything except for food and bullets maybe.

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    • Joshua Northey says:

      Maybe, maybe not. I think a situation where the US descends into civil war, or massive civil disorder and is unable to raise the taxes to service its debts while the rest of the world does relatively ok is at least non-zero. In which case investing in other countries might be perfectly safe.

      Yes the US is probably still one of the the safest debtors, but I don’t think a US default necessitates global apocalypse like people think it does.

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      • mary says:

        Raising taxes won’t service the debt. Raising taxes almost certainly would not add significantly to revenue. Lowering taxes has a better chance of raising more revenue. This has been demonstrated many times in the real world.

        Anyway, revenue is not the problem. If you look at any graph of revenue and expenses for the USA, the revenue has generally been healthy and increasing. Expenses, however began soaring under Bush and absolutely exploded under Obama. It’s a bi-partisan boondogle.

        Spending control is the only way out of this mess.

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  3. Caleb b says:

    1) the US won’t ever default bc it can always print money. Done.
    2) the reason treasuries rallied is bc there is simply no where else to park you money. It’s a supply issue. There is an extremely large amount of invested money out there and very few flight-to-quality investments. Gold? Sure, but you earn no interest. Euro debt? Please. The stock market dropped ~ 600pts as funds moved from equities to US debt, but not bc US debt is a good investment, bc the market is pricing in lower earnings from stocks, meaning they’ll be cheaper later. So sell stocks now, move to T-bills and check back later.

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  4. JoelP says:

    Does this make US debt risk a Giffen Good?

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  5. Allan Lewis says:


    I thought it was now well established that current financial models are inadequate. Many professionals may continue to use them but empirical evidence is strong that the behaviour of many actors is inconsistent with the assumptions underlying the models.

    I am not surprised by the response of the US bond market to the S&P downgrade. The short term response is much less important than the longer term outcome.

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  6. Alastair says:

    Modern finance has fallen apart – it has no idea how to price risk. Hadn’t you noticed?

    Slightly more seriously, one interpretation of this story would be that investors are making their own judgments, independent of ratings agencies. Given the agencies’ performance in the subprime crisis, that’s probably no bad thing.

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    • slsholder says:

      Alastair… Modern finance has not actually fallen apart… it has been twisted, skewed and misdirected by social activists offering tax incentives and inappropriate, federal insurance to promote their agendas and re direct risk to the Fed Govt. This re-directs wealth and property to high risk individuals and groups (orgs and corps) who cannot support it or that do not adequately understand how to implement long-term financial planning or physical maintenance. Risk should reside and remain with the investor and the investee, as much as possible, because it instills a greater sense of responsibility to avoid failure. When we transfer risk to third parties with inappropriately deep pockets, investors and the investees do not guard against loss as vigilantly.

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  7. Tg3 says:

    Did we not learn, in the process of tracing the causes of the 2008 financial mess, that S&P do not do a good job of accurately accessing risk? Should it not be surprising that the market has a better idea how risky US treasury notes are than S&P?

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  8. slsholder says:

    An aspect jumping to treasuries may be Pavlovian conditioning, ’cause Ts are the traditional and most reliable past shelter for many decades. Fear triggers automatic, conditioned responses toward traditional safety. In North America, aquatic frogs typically respond to danger by jumping into water, ‘caus threats usually come from land. In South America they jump to land, ’cause most threats usually come from water. With atypical and confusing events, misinformed, conditioned flight can place all three where hindsight shows was a mistake.

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