Will S&P downgrade the US?

By Felix Salmon
April 18, 2011
revised its outlook on the US sovereign credit rating:

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It’s known as Stein’s Law: if something can’t go on forever, it won’t. And it’s the reason S&P has now revised its outlook on the US sovereign credit rating:

Because the U.S. has, relative to its ‘AAA’ peers, what we consider to be very large budget deficits and rising government indebtedness and the path to addressing these is not clear to us, we have revised our outlook on the long-term rating to negative from stable.

We believe there is a material risk that U.S. policymakers might not reach an agreement on how to address medium- and long-term budgetary challenges by 2013; if an agreement is not reached and meaningful implementation does not begin by then, this would in our view render the U.S. fiscal profile meaningfully weaker than that of peer ‘AAA’ sovereigns.

Note the internal contradiction here: S&P first says that the US already has a significantly worse fiscal situation than its AAA peers, then there’s a slight backpedal to say just that it might be weaker than its peers, fiscally speaking, if it doesn’t bite the budget bullet by 2013.

The first statement is the more accurate. S&P has three macroeconomic scenarios: baseline, where the US debt-to-GDP ratio reaches 84% in 2013; optimistic, where it’s 80%; and pessimistic, where it’s 90%. “Even in our optimistic scenario,” they write, “we believe the US’s fiscal profile would be less robust than those of other AAA rated sovereigns by 2013.”

With debt-to-GDP north of 80%, it becomes very hard for the US to pay for another large shock. According to S&P, fully recapitalizing Fannie and Freddie could cost 3.5% of GDP, other government-guaranteed debt (like student loans) could also cause enormous losses; and another banking crisis could cost a whopping 34% of GDP. And that’s before you even start thinking about the inexorable rise in Medicare costs as healthcare costs rise and the US population ages.

Meanwhile, the US might not have foreign debt, but it has a very large amount of external debt — its external debt as a proportion of current account receipts “is one of the highest of all the sovereigns we rate”, says S&P.

Where S&P does not go into any detail is on the question of how any of this might end up with a debt default. That’s probably sensible: there are so many conceivable ways to get there from here, all of them very unlikely, that it’s silly to try to game them out. The US can always avoid default if it wants. But as the options for avoiding default become increasingly painful, in terms of fiscal cutbacks and/or inflation, the probability of a default, while always low, is liable to rise.

Now that the US is on negative outlook, there’s at least a one-in-three chance that the US will lose its triple-A credit rating in the next two years. Or that’s what S&P is saying, anyway. I’m not convinced: the entire S&P business model is based on the idea that creditworthiness is a one-dimensional spectrum which ranges from risk-free, at one end, to defaulted debt, at the other. If US Treasury bonds aren’t risk-free, then nothing is risk-free, and the triple-A bedrock on which the S&P ratings apparatus is built crumbles away.

Conceptually, that’s no bad thing. The search for risk-free assets was a major contributor to the global financial crisis, and forcing investors to navigate a relativistic world where risk can be allocated but not eliminated is a great way to help address the fundamental treachery of debt.

And the US losing its triple-A now, post-crisis, would not be nearly as harmful as if it had lost its triple-A before the crisis, just because at this point the ratings agencies have lost most of their credibility.

Still, it would be a huge shock to the financial system. Because of the way that sovereign ceilings work, a US downgrade would probably mean that just about everything else in the US which is rated AAA — including all municipal bonds, and thousands of structured products — would also get downgraded.

What would escape the scythe? Foreign sovereigns, perhaps, like France, Germany, Canada, and even the UK. (But does anybody really believe that the US would be less creditworthy than the UK or France, no matter what S&P says?) Maybe some multilaterals, like the World Bank. But certainly not enough to stop the global supply of triple-triple assets (that is, bonds which are rated AAA by three different ratings agencies) being essentially wiped out at a stroke.

As I say, I like the idea of a world where nothing is triple-A and everything is relative. But there’s a large and real cost of getting there from here. And a lot of that cost would be borne by S&P itself. Which is why I suspect that while the agency might threaten a US downgrade, it will ultimately hold off from pulling the trigger.

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