The Rating Game: Is U.S. Debt Set for a Downgrade?

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The Rating Game: Is U.S. Debt Set for a Downgrade?

Post by Dr. Manhattan on Tue Jun 14, 2011 7:52 pm

The Rating Game: Is U.S. Debt Set for a Downgrade?

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Daniel Gross, On Tuesday June 14, 2011, 7:10 am EDT

Given their general cluelessness during the mortgage bubble, the three main credit ratings agencies — Standard & Poor's, Moody's, and Fitch — might be better known as Hear No Evil, See No Evil, Rate No Evil. And as sovereign debt crises bubbled up in Iceland, Greece, and Portugal, the professional credit-watchers always seemed to be the last to know.

But now the Three Amigos are determined not to be behind the curve. With an August 2 deadline looming to increase the debt ceiling, all three have now put the U.S. on notice that its top-notch credit rating should no longer be viewed as an entitlement. A credit rating is like a credit score, but for countries instead of for individuals. The U.S. and a handful of other developed countries enjoy AAA ratings from Standard & Poor's. (An explanation of the agencies' credit rating schemes can be seen here.)

First out of the gate was S&P, which changed its outlook on U.S. debt from "stable" to "negative" in April. As the Wall Street Journal notes, that means there is a one in three chance the agency could downgrade the U.S. in the near future.

In early June, Moody's, warning that the risk of the U.S. government defaulting on its debt was "very small but rising," said that if the paralysis over the debt ceiling "remains unchanged in coming weeks, Moody's will place the rating under review."

Now Fitch is saying that it might put the U.S. on watch for a downgrade in early August if Congress fails to raise the debt ceiling.

What does this mean? What are the effects of a downgrade? And how will it affect markets, the financial system, and the savings of people around the world? After all, U.S. government bonds are one of the most widely held assets in the world.

In the accompanying video, Aaron Task and I discuss the ratings game.

t's rare for AAA-rated countries to lose their status. But it does happen. As the Journal noted, since 1989, Standard & Poor's has placed "negative" outlooks on 5 AAA-rated countries. Of those, three were ultimately downgraded. (One of those was the U.K., which won its AAA rating back in relatively short order.)

Ratings are an opinion on how likely it is that creditors will be paid back. All things being equal, a lower rating means investors will demand to be paid more in order to keep investing. So if the agencies downgrade America's sovereign debt, in theory it would mean the government would have to pay higher rates on its debt.

A downgrade would cause broader problems. As interest rates rise, the value of existing bonds falls. And so all the institutions — pension funds, banks, insurance companies — that hold government bonds and classify them as low-risk capital would be hit by the reduction in value. In addition, higher government borrowing rates tend to filter through into the rates consumers pay for mortgages, auto loans, and credit card debt.

The real danger for countries is that the first downgrade might not be the last. When the agencies ratchet down ratings several notches to the 'B' level, from investment grade to non-investment (or junk) grade, that's when problems really kick in. Many pension funds, mutual funds and other big institutions are prohibited from holding lower-rated debt. And so a series of downgrades can trigger a wave of selling at a bad time.

Are there objective conditions that would automatically cause a downgrade? Not really. The ratings agencies, while relying largely on quantitative measures, also utilize qualitative judgment. There's no magic level of debt that triggers a downgrade. As this graphic from the Wall Street Journal shows, Canada's deficit is 5.5 percent of its gross domestic product while America's is more than 10 percent of GDP. Both have AAA ratings. Total government debt in the U.S. is 91.6 percent of GDP, compared with 22.3 percent for Australia. Both have AAA ratings.

Ratings are less about how much debt a country has, and more about nations' ability to stay current on payments, their willingness to take the actions necessary to stay solvent, and underlying economic trends. Political and even cultural issues often come into play. Greece, which has a widespread culture of tax avoidance and whose government has proven unable to control spending, can't handle the same level of debt that countries with more functional tax and political systems can.

What's more, investors should know that the credit rating is only one among many factors that influences the price of bonds, and hence interest rates. Economic growth, inflation, monetary policy, fear, and greed all influence interest rates. Even as the U.S. has expanded its balance sheet, interest rates have remained low, in part because investors continue to view U.S. bonds as a safe haven in a turbulent world. And so while the U.K. and the U.S. enjoy the same AAA rating, the British government pays about 3.2 percent to borrow for ten years, while the U.S. pays 2.99 percent. Meanwhile, Japan, which S&P downgraded from AA to AA- in January, pays incredibly low interest rates to borrow. According to Bloomberg, its 10-year bonds yield just 1.15 percent.

The bond rating agencies are generally very conservative. (Just today, several months after it became obvious that Greece would be unable to pay its debt, Moody's "lowered Greece's debt ratings by three more notches and signaled further downgrades could come.") Downgrading the U.S. would be a bold, even radical step for the rating agencies. And it's something they would prefer not to do. These warnings can best be viewed as an attempt to warn Washington that it shouldn't dither on raising the debt ceiling.

Daniel Gross is economics editor at Yahoo! Finance

Email him at [You must be registered and logged in to see this link.]; follow him on Twitter @grossdm

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Dr. Manhattan

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