The Biggest Shock of All

Why did the specter of collapse in far-away Hungary help sink the Dow by 323 points on Friday?

And why did similar scenarios in Greece, Spain, and Portugal trigger the Dow’s 1,000-point Flash Crash one month earlier?

Is it because those countries are so important to the future of America’s blue-chip corporations?

Not quite!

It’s because investors around the world are finally waking up to some shocking realities:

Shock #1 is that these countries are canaries in the coal mine — the first of many that could suffer the wrath of investors fed up with runaway deficits.

Shock #2 is that, in the UK and the US, federal deficits and total debts, as a percent of GDP, are similar to — or even larger than —those of Greece, Spain, Portugal, or Hungary.

Shock #3 is the recurring revelations of official deceptions. Investors suddenly discover that unemployed were counted as employed … that government debts were disguised as capital … that far bigger federal deficits were camouflaged. And it is these revelations that trigger the biggest selling panics, that are the final nail in the coffin for companies and entire countries.

But Shock #4 is the biggest and most dangerous of all — not just random deceptions by a few companies or a few countries, but a global deception in the credit ratings that investors rely on for nearly ALL companies and countries!

With gathering momentum right now, investors are beginning to realize they can’t trust the ratings issued by established agencies like Moody’s, Standard and Poor’s, and Fitch.

But this is not merely bad news for the agencies themselves. It’s also a powerful force that can drive global stock and bond markets into a nosedive.

When companies are downgraded, their share and bond prices automatically fall.

So think about what it means when the grading system itself, encompassing thousands of ratings on trillions of dollars in securities, crumbles!

It implies, in effect, a collective downgrade of nearly ALL the securities in the world — every rated corporate bond, municipal bond, and even government bond in existence!

Needless to say, this transformation is too massive to happen overnight; it will progress in three phases.

Phase 1
Widespread Loss of Confidence in
The Leading Rating Agencies

In the first phase, regulators, analysts, and investors begin to raise serious questions about the validity of ratings:

Is a bond really triple-A? Or is the rating agency just maintaining the high grade because it wants to protect a good client that’s paying fat fees for its ratings?

Beyond triple-As, what about the hundreds of thousands of corporate, municipal, and sovereign bonds that currently boast other “investment grade” ratings? How many are really speculative grade — junk — in disguise?

Right now, Congress is asking these questions daily, attacking the rating agencies and getting ready to take action against them as part of the upcoming regulatory reform.

And the assaults on the rating agencies by independent commentators are even more strident …

In “Answers on Credit Ratings Long Overdue,” Andrew Sorkin of the New York Times puts it this way:

“Raise your hand if you can explain why anyone still believes in credit ratings. … How could century-old institutions like Moody’s Investor Service give their triple-A blessings to subprime junk? … How can we prevent these institutions and their sometimes cockamamie judgments from endangering our financial system again?”

In his testimony before Congress on Wednesday, Warren Buffett (a major shareholder in Moody’s) said the agencies ought to be forgiven for their sins — particularly for giving junk mortgages triple-A ratings.

But that same evening, on a Kudlow Report segment, “The Future of the Credit Rating ‘Cartel‘,” both the CNBC host and commentator said flatly that …

The ratings issued by Moody’s and S&P are “garbage.”

CNBC commentator Don Luskin added:

“Shame, shame, shame on Warren Buffett for saying the rating agencies are to be forgiven. … We’ve got the Obama administration talking about bringing criminal charges against BP. Why don’t we bring criminal charges against the rating agencies …?”

On the same CNBC segment, I was asked for my solution, which I’ll get to in a moment. But first, let me tell you my forecast regarding the next phase …

Phase 2
Massive Investor Selling

Here’s what I see happening …

Until and unless the rating agencies abandon their conflicted business model, extreme doubts about credit ratings will spread like wild fire.
Investors will scramble to reassess the risk in the trillions of dollars of rated securities they own.
They will decide, independently, what the true ratings should be, effectively issuing their own downgrades on thousands of securities.
And, they will SELL.

This forecast takes no particular foresight. As illustrated by the recent barrage of attacks on the rating agencies, the global risk reassessment has already begun. And as illustrated by recent sharp price declines — in sovereign bonds, corporate bonds, derivatives, and common stocks — the selling has also already begun.

Phase 3
Capitulation by the Rating Agencies

My next forecast, however, does require looking further ahead:

The day will come when, due to overwhelming pressure from regulators, investors, and even some debt issuers themselves, the leading rating agencies will have no choice but to cave in.

Moody’s, S&P and Fitch will announce downgrades for hundreds of major debt issuers in one fell swoop. Or they will seek to wipe the slate clean by revamping their rating scales, effectively downgrading nearly ALL of the bonds they rate.

I have no doubt this will happen. The only major uncertainty is: when?

Will it be before millions of investors each make up their own minds about what every rating should be?
Or will it be after investors make up their own minds — when there is such a sorry state of confusion and panic that the rating agencies are FORCED to act to restore a semblance of credibility for themselves and the companies they rate?

Either way, we can now see the makings of an all-out selling panic — first in corporate bonds, then in the most vulnerable common stocks. It is the natural outcome of the global downgrading of ratings and rating agencies themselves. It’s coming very soon. And it’s going to hit hard.

Too Late for Easy Solutions

At Weiss Ratings we don’t take a dime from the companies we rate. We’re not even beholden to the companies for the supplemental data we request. If they choose not to give us the information, we rate them based exclusively on publicly available data.

However, we also believe that no one should tell our competitors what business model to use. Rather, as we proposed to the SEC more than seven years ago — and as we proposed again to Congress last week — the U.S. government must cease blessing these conflicted rating agencies and stop requiring investors to rely on them.

If this solution had been implemented years ago, the rating agencies might have had time to adjust, the mortgage ratings fiasco might never have happened, and the market debacle I am forecasting would be far less likely.

Today, however, it’s too late for moderate or easy solutions. If the government does not act as proposed, the markets will. There really is no choice.

The Next Big Question …

If even a company’s supposedly “investment grade” bonds are suspect, how can anyone trust their shares?

The answer to this question is about to come very soon. So if you haven’t done so already, be sure to batten down the hatches.

Heed “Our Sixth Warning: Dow in Danger!” Move swiftly. Do not procrastinate.

Good luck and God bless!

Martin

About Money and Markets

For more information and archived issues, visit http://legacy.weissinc.com

Money and Markets (MaM) is published by Weiss Research, Inc. and written by Martin D. Weiss along with Nilus Mattive, Claus Vogt, Ron Rowland, Michael Larson and Bryan Rich. To avoid conflicts of interest, Weiss Research and its staff do not hold positions in companies recommended in MaM, nor do we accept any compensation for such recommendations. The comments, graphs, forecasts, and indices published in MaM are based upon data whose accuracy is deemed reliable but not guaranteed. Performance returns cited are derived from our best estimates but must be considered hypothetical in as much as we do not track the actual prices investors pay or receive. Regular contributors and staff include Andrea Baumwald, John Burke, Marci Campbell, Selene Ceballo, Amber Dakar, Roberto McGrath, Maryellen Murphy, Jennifer Newman-Amos, Adam Shafer, Marty Sleva, Julie Trudeau, Jill Umiker, Leslie Underwood and Michelle Zausnig.

Attention editors and publishers! Money and Markets issues can be republished. Republished issues MUST include attribution of the author(s) and the following short paragraph:

This investment news is brought to you by Money and Markets. Money and Markets is a free daily investment newsletter from Martin D. Weiss and Weiss Research analysts offering the latest investing news and financial insights for the stock market, including tips and advice on investing in gold, energy and oil. Dr. Weiss is a leader in the fields of investing, interest rates, financial safety and economic forecasting. To view archives or subscribe, visit http://legacy.weissinc.com.

From time to time, Money and Markets may have information from select third-party advertisers known as “external sponsorships.” We cannot guarantee the accuracy of these ads. In addition, these ads do not necessarily express the viewpoints of Money and Markets or its editors. For more information, see our terms and conditions.

15430 Endeavour Drive, Jupiter, FL 33478

Sign Up Free