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S&P Downgrade Adds to Crisis of Confidence

And the hits keep coming ... . After the worst week for stocks since the debt crisis of 2008-09, Standard & Poor's has followed through on its warning and downgraded U.S. debt for the first time in history.

This certainly adds to the crisis of confidence making its way through the market. Will this cause interest rates to spike and add to the price America has to pay to service its debt? Maybe, but the way investors continued to pile into Treasuries this week, even knowing this downgrade could be on the horizon, raises some doubts about it.

More than anything, this is a political embarrassment for President Obama and Congress. But if rates do rise, guess who gets to pay the price? We all do, no matter which dysfunctional political party you're affiliated with.

The week of course seemingly started with a sense of optimism and relief after U.S. politicians finally came to an agreement on the debt ceiling. But it ended with confusion and a global crisis of confidence.

The Dow Jones Industrial Average rose 60 points for the day, but not before a 416-point swing in intraday trading. The S&P 500 closed the day essentially flat, and the Nasdaq fell nearly 1 percent. Overall, it's the worst week on Wall Street in more than two years, as the S&P 500 fell more than 7 percent, and the Dow was down 5.8 percent. That's an exhausting ride.

In the U.S., markets lost confidence in lawmakers after the debt compromise failed to appease either party or the American public. The crisis essentially did two harmful things. First, it removed hope of more government stimulus and eased the chance of QE3. (See: The Government Can't Save the Market This Time). Second, for those who were hoping the debt talks would help correct America's fiscal mess, the deal fell far short.

This current crisis might not be 2008-09 all over again, as Daniel Gross argues in the clip. But in Europe, things are looking eerily similar and bad. Europe's sovereign debt crisis and the potential impact on the eurozone banks is of grave concern on the continent. The good news is that Italy finally woke up to its mounting fiscal problems, promising to work on a constitutional amendment requiring a balanced budget. That may have calmed the situation for now, but if things should worsen, Italy is viewed as too big to bail out, and no one knows how that would be resolved without first creating a crisis.

In her most recent column, the Financial Times' Gillian Tett details the parallels between what's going on with the European sovereign debt crisis and the U.S. debt crisis of 2008-09.

● When Greece first started to wobble, many policymakers -- and some investors -- tried to downplay it because Greece is so small relative to global markets — with less than €200bn of foreign-held central government debt. Similarly, Lehman Brothers and Bear Stearns, with assets of $600bn and $400bn, were also small compared with the US financial sector.

● Similarly, when the troubles erupted, eurozone policymakers initially assumed that the problem was a liquidity, not solvency, issue, and blamed the problem on "speculators." Thus they repeatedly unveiled sticking plaster (or Band-Aid) solutions that tried to delay tough decisions and paper over the cracks. This was similar to what the US authorities did in late 2007 (remember the ill-fated super-SIV plan?) It has proved no more successful in the eurozone than it was in the US: though each new announcement produces a modicum of relief, investors keep baying for a more comprehensive solution.

● This has now forced some eurozone leaders to move to a new phase and admit something they long denied: namely that Greek debt will need to be restructured and not everybody will always be bailed out. On one level this is sensible; reality is finally starting to bite. But on another, it takes the crisis to a new level -- again, following the 2008 playbook. For what eurozone governments have done is push investors across a crucial psychological Rubicon - and make them [realize] that assets that used to seem risk-free now carry credit risk. As shocks go, this is perhaps comparable with the US government's decision to put Fannie and Freddie into conservatorship in the summer of 2008. A sacrosanct assumption is being overturned; investors no longer know what to trust.

● Unsurprisingly, this is stoking a contagious sense of fear. The traditional investors in eurozone bonds (just like the investors who were holding Fannie and Freddie bonds or triple A mortgage assets in 2008) have little experience in assessing credit risk. Thus they find it hard to judge which countries are "safe," or to price for that risk. Worse still, very few investors (or even regulators) really understand the complex web of interconnections between the eurozone banks. The issue is not merely loans and holdings of eurozone bonds; there is limited granular, real-time data on credit derivatives exposure. And getting a sense of a bank's real "whole country" exposure is tough, since banks stopped measuring their risks this way in recent decades.

In other words, the world's economic problems aren't getting any easier to solve, and so far, at least, none of the government or private-sector solutions, if they can be called that, have soothed investors. For that to happen, we're going to need certainty, or at least a period in which crises are limited if not nonexistent. Raise your hand if you're expecting that to start any time soon.

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