Why the U.S. Credit Rating Downgrade Could Cause a Full-Fledged Market Crash

Article of the Week from Money Morning

by Jason Simpkins, Managing Editor, Money Morning

That Standard & Poor’s finally downgraded its U.S. credit rating surprised no one – the agency said weeks ago that it would require a deficit-reduction agreement of around $4 trillion to affirm its AAA rating on the United States.

But what the ratings agency doesn’t realize is that it’s playing with fire. Because what we’ve seen over the past few weeks has been a massive sell-off in the stock market that suggests Wall Street’s biggest players are scrambling to bolster their net capital positions.

And it’s entirely possible that this already-stiff correction will snowball into a full-blown market crash.For months, years even, many of these firms have leveraged their Treasury securities to borrow more money to buy more government bonds and other – more speculative – investments. But since Treasury bills, notes, and bonds can no longer be considered “risk free,” institutions are being forced to recalculate their net capital positions to accommodate the added risk.

In industry parlance, this is called a “haircut,” and it’s exactly what Money Morning Contributing Editor Shah Gilani warned about back in July.

“After studying everything that could happen due to a downgrade of the United States’ top-tier AAA credit rating, and the potential default on its debt, we found a scenario that would result in forced asset sales that are so widespread that global stock-and-bond markets would plunge — and economies around the world would crash,” said Gilani.

Gilani now says that we could be seeing the beginning of a “global margin call” that will continue to ravish global markets.

The Dow Jones Industrial Average plunged more than 631 points, or 5.52%, yesterday (Monday), after falling 6% last week.

“The sell-off itself got uglier later in the day as margin calls likely triggered more liquidations when there was no bounce after the opening downdraft,” Gilani said in an interview. “This is very worrisome. If we don’t get a bounce Tuesday morning, but instead see a bad opening, margin calls will ramp up and the effect of rolling collateral and margin calls could turn this correction into a full-fledged crash.”

Market Mechanics

Gilani says what happens next boils down to margin mechanics and counterparty risk.  “It’s the market’s ‘mechanics’ that presents the greatest danger, which 98% of investors, including professionals, aren’t seeing. The focus now has to be on margin mechanics,” says Gilani. “More margin calls mean more pain and much, much longer recovery from wherever the markets bottom out. The next few days are super important.”

Gilani says this was made evident yesterday by the downgrades of several major clearinghouses and government-related entities.

Companies downgraded to double-A-plus with a negative outlook were: Knights of Columbus, New York Life Insurance Co., Northwestern Mutual, Teachers Insurance & Annuity Association of America, and United Services Automobile Association.

Companies affirmed at AA-plus with their outlook lowered to negative were: Assured Guaranty Corp., Berkshire Hathaway Inc. (BRK.A, BRK.B), Massachusetts Mutual Life Insurance Co., Guardian and Western & Southern Financial Group Inc.

“Any panic grab for collateral, and principally I’m fearful of this happening in thederivatives marketplace, would engender counterparty fears,” Gilani said. “We’ve seen insurance company downgrades today, so the questions are being asked: What’s the real level and quality of their capital, and do they have skeletons in the closet?”

With so much risk abounding, it’s important that investors not panic, but rather prepare. They can do that in a number of ways, including:

•Buying gold: Gold prices hit a record high of $1,718 an ounce in intraday trading yesterday (Monday) in response to Standard & Poor’s downgrade of the U.S. credit rating, and the continuing drumbeat of dreary global economic news will keep pushing the yellow metal higher.
•Investing in high-yielding, large-cap stocks: Large multinational companies that pay juicy dividends will be less susceptible to a market downturn, and could even prove to be bargains during a rebound.
•Employ inverse funds: Exchange-traded funds like the Rydex Inverse S&P 500 fund (MUTF: RYURX) move up as the market goes down, making them a viable hedge.

More outstanding articles from Money Morning

Shah Gilani: We Haven’t Hit Bottom Yet (Aug. 12)

Time to Profit, Not Panic, from the Stock market Sell-Off

Toothless Debt Deal Won’t Stop U.S. Credit Downgrade – Or the Aftermath that Follows

Why a U.S. Default Will Be a Good Thing

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