Stein?s law states that ?If something can?t go on forever, it won?t?. Last Monday, rating agency Standard & Poor?s (S&P) downgraded the outlook on the US sovereign credit rating from stable to negative. Statistically, the odds are one-in-two that the US will lose its AAA credit rating in the next two years. It is the first time in the last 70 years that the US has been given a negative outlook. The statement that came from S&P following the revised outlook reads like a paraphrasing of Stein?s law. It states that the US has a ?very large budget deficit and rising government indebtedness?, which don?t seem sustainable.

This announcement by S&P led to a 20.9% widening in the US credit default swap, a product that insures against a debt default. Dow Jones Industrial Average too fell by more than 140 points. S&P?s primary credit analyst Nikola G Swann attributed the main reason for the negative outlook to the escalating federal budget deficit, and a staggering US debt ($14,300 billion and growing). He also pointed at the lack of will to come with a credible plan to address the fiscal mess, given the partisan politics and the ensuing gridlock that recently almost forced a government shutdown. He said, ?More than two years after the beginning of the

crisis, US policymakers have still not agreed on how to reverse recent fiscal deterioration or address longer-term fiscal pressures.?

The US can always avoid default if it wants. But the options for avoiding default will become increasingly painful, in terms of fiscal cutbacks and inflation. It is difficult to imagine what it would be like if the largest sovereign borrower were to default. Even a downgrade to AA from the current AAA, which has a likelihood of more than 30%, would be a huge shock to the financial system. This is because of the way sovereign ceilings work. For instance, a State Bank of India cannot possibly have a higher rating than the Government of India. Similarly, a US Government downgrade would mean that just about everything else in the US that is rated AAA will get downgraded. This would include government sponsored agencies like Fannie Mae and Freddie Mac, almost all AAA-rated American corporations, and thousands of municipal bonds. Most of these debt instruments are currently ?triple-triple? assets, that is, they are rated AAA by the three principal ratings agencies?S&P, Moody?s and Fitch. In fact, if the government goes one notch lower, US entities across the ratings spectrum would go down a grade as well. A large number of concurrent downgrades could cause a huge shock to the financial system.

US Treasury secretary Tim Geithner has criticised S&P for the outlook change, stating that it wasn?t warranted. Powers-that-be in the government need to have the perspective that Swann is just a messenger, and shooting the messenger down is not going to solve the problem. Somebody else, if not Swann, would have pointed out that the emperor is wearing flimsy clothes. The government has been feeding on leverage for long and reducing the debt diet would mean withdrawal pains. Swann?s statement indicates that the government doesn?t seem to have the will to brave the discomfort. The government spent $1,293 billion more than it earned in 2010 and that number is expected to be $1,645 billion this year. The government?s projected fiscal deficit for 2012 is also expected to be north of a trillion dollars. These estimates factor in obvious costs like increased healthcare expenditure but do not account for possible losses like that from government guaranteed debt made during the financial crisis. Therefore, given the planned budgetary allocations, the US government will be taking on even more debt for at least the next two years. More debt to cure problem of too much debt is not homeopathy?it is denial. The financial market may not be patient for that long, which means that at some point it may snowball into a sovereign crisis. The possibility is not as far-fetched as it seems.

Ironically, Swann has highlighted the risk of a tail-event like a large simultaneous rating downgrade that Nassim Taleb talks about in his book The Black Swan. The theory of black swan events postulates that extreme events do happen more frequently than we anticipate. In this case, a swan is used as metaphor as they are always thought to be white. Logicians, for centuries, had used a ?black swan? as a symbol of non-existence and falsification. And then suddenly, out of the blue, zoologist found a species of black coloured swans in Western Australia. In the same way, we don?t expect a downgrade in US sovereign rating. Nor can we envisage a substantial number of downgrades of triple-triple assets. Yet we need to be better prepared for such shocks. Who would have imagined in 2006 that a crisis would emanate in America as they were always thought to be an ?emerging economies? disorder. Swann has unwittingly underscored the odds of a black swan event.

The author, formerly with JPMorgan Chase, is CEO, Quantum Phinance