The S&P downgrade of the Federal Government

I've been a (moderately) active investor since I've had two nickels to rub together (circa 2006).  Between then and now, I've watched the market be relatively stable, crash, stabilize, crash again, bounce, and crash again while I'm typing this.

Today's drop can be directly attributed to Standard & Poor's (S&P) downgrading the federal government's credit rating, from AAA (the highest) to AA+ (the second highest). 

This has rattled investors, who have started indiscriminately selling stocks to put their money into cash. 

However, I would argue that this sell-off has much more to do with fear and confusion than it does to do with any sort of financial reason.

Note to Government: Stop doing anything.

The one thing I have learned from investing is that federal government action = stocks go down.  Obama talking about the economy = stocks go down.  Congress doing anything = stocks go down.  Congress does nothing and it shows up on the news = stocks go down.

The debt ceiling debacle has smacked the economic recovery in the face.  We can handle the fact that our elected officials are corrupt or that they're imbeciles.  But we never realized how badly their idiocy could fuck us until the country was brought to the brink of default for political reasons.

What the hell is S&P and what is its function? 

Standard & Poor's has a super-important sounding name.  S&P is the name of a stock index that shows up on the news along with the Dow Jones Industrial Average and the NASDAQ.  It has the word "Standard" in it.  Is it a government agency?  What sort of power does it have?

Well, S&P is actually a private company, owned by McGraw-Hill.  Yes, McGraw-Hill the book publisher. 

Its function is as a "ratings agency."  A ratings agency is a company that rates (assesses the ability of borrowers to pay back loans) debts that are for sale.  In the federal government's case, the government issues bonds to raise money.  A government bond is an IOU from the government, stating that they will repay the IOU plus interest.  A downgrade of the federal governments rating means that S&P believes that there is a higher likelihood of the federal government electing to not pay back their IOUs. 

S&P rates all sorts of bonds, from straight corporate bonds to bonds backed up by assets (such as mortgages).  For the record, a whole lot of loans that rating agencies (including S&P) said had virtually no chance of going bad did just that during the financial crisis.  Investors who relied on the ratings and thought they were being conservative were hit hard.  S&Ps inflated ratings were most likely caused by either (i) not knowing what they were doing, or (ii) refusing to give bad ratings to the bond issuers, who coincidentally were paying the rating agencies to produce the ratings.  S&P was nice enough to lower their ratings during the financial crisis, thus throwing more gas on the fire that they helped to start.

What does the downgrade actually mean? 

The interesting dynamic here is that the federal government can print money.  It can literally turn on a printer and produce bills.  It's like lending someone on a beach a bunch of sea-water and telling them that they need to pay you back a bucket of sea-water every month.  That borrower can always get more water- the only risk to the lender is that the borrower refuses to do so.  Likewise, the question is not whether the government can pay its debts, but instead the question is will the government refuse to pay its debts.

Essentially, the downgrade is directly tied to the government's inability to get things done.  If one of the two parties is willing to use government default as leverage to get its way, it naturally follows that eventually the other side will refuse to budge.

So, what's the end result?

Investors are selling their shares and getting out of the market.  In a different time, the market might having other investors coming in to the market to buy stocks at a discount.  After the financial crisis, investors know that just because a stock is cheap, it can still get cheaper (much, much cheaper). 

Americans have no real faith in the government to address the nation's financial problems.  If the debt ceiling debate (which was, at best, an egregious waste of time and resources) could almost sink our economy, what faith should we have in government to actually make progress?  The financial rules are constantly in flux and Washington's indecision is causing corporate America to sit on its collective hands.  Companies are incentivized to hold their money until there is more clarity (such as figuring out where this extra $1.5 trillion in budget cuts are going to come from).  The economy was stuck in neutral, and now our government has attached a trailer to it. 

So, when you hear Republicans blaming Democrats and vice versa, know that the problem is not that either party's plan was neccessarily better, but that no one knows if they can stop bickering long enough to repay the pail of water every month. 

As for S&P, they aren't telling us anything we don't already know.  The timing, however, could not be worse.   Gas, meet fire. 

In conclusion, what we have here is on-going failure on behalf of our elected officials.  And the downgrade?  That's just a non-trustworthy private company telling us that idiots (Congress) will continue to act like idiots, which should not be a surprise to anyone.