Trader Talk

Why Markets Rose—and Fell—Today

S&P 500 and the Nasdaq briefly go positive before falling back...why aren't we down more? Why did we rally at all? Traders are betting a deal will get done. President Obama said earlier that Democrats and Republicans are not far apart on an agreement to raise the debt ceiling.

"I'm long, Bob," one trader wrote near the bottom this morning. "People have to bet that these clowns get it done over the weekend...that is the massive odds on play," he said.

Another wrote: "Sorry, was too busy buying buying/covering everything in sight...I think something DOES get worked out over the weekend-- will be a last minute scramble...but concerns are overblown."


What will happen to equities if the debt ceiling is extended, but there is a credit rating downgrade? A majority of the traders I have spoken to believe that a downgrade of U.S. debt from at least one credit agency is coming because there will not be a strong enough agreement on cutting the deficit.

First, it's bigger than US Treasurys. A large number of AAA-rated securities would lose that rating. Standard and Poor's has said that in addition to a downgrade of US Treasurys, the debt of Fannie Mae, Freddie Mac, the Federal Home Loan Banks, the Federal Farm Credit System Banks and AAA-rated U.S. insurance groups might also be downgraded.

1) These investors want yield, so an obvious potential choice are stocks with safe (and relatively high) dividends.

2) Insurance companies would be the most exposed to risk since they have large exposure to those (formerly) AAA rated instruments. The quality of their assets would be lower, which would likely result in higher capital requirements.

3) Mortgage insurers would be hurt by a rise in Treasury yields, since mortgage rates would rise, hurting home sales. It would also affect holders of Adjustable Rate Mortgages (ARMs). Remember them?

4) The impact on banks is a real wild card. Several traders have noted that there is a risk that some banks could be downgraded, since there might be an implication that banks that have systemic support from the U.S. government might have less support. This seems like a stretch to me, but it has been brought up.

Other concerns for banks are more real:

a) repos (repurchase agreements) might be more costly. Many banks rely on repos for short-term funding; the banks get cash in exchange for posting Treasurys as securities. If Treasurys were downgraded, banks should logically be required to post more collateral. This may not be a problem if there is no panic, but remember what happened to the short-term paper market during the crisis in 2008?

b) tangible book value would likely decline due to the lower likely prices on Treasurys that banks hold, but it's not clear how much.

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