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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S&P has no credibility at all. Remember how well it did on rating mortgage related securities.

Treasury yields are at very low levels. This should tell us something.

Posted by 3oosion | Report as abusive

Felix, you and your boss Peter Peterson can’t escape the fact that the debt is in the government’s own fiat currency.

It CAN go on forever just like it’s gone on since 1776.

Too bad nobody’s as interested in writing about our massive unemployment and the very real legacy that will leave.

Posted by petertemplar | Report as abusive

S&P is, of course, trying to recoup cedibility it and the other rating agencies lost in the financial crisis, when all three agencies actually participated in furthering the scams that finally blew up in their faces in late July, 2007. It can be argued S&P is trying too hard to recoup that lost credibility. It can also be argued that it is trying to shock politicians into getting serious about resolving U.S. debt crises. But, having recognized all the foregoing cynical factors, I still believe S&P’s move carries enough credibility to be taken seriously – that it is sufficiently based upon the facts as to warrant action now on the part of investors. We’ll have to see if I am right. What actions will global investors take, if any, now? Where will the dollar go from here? Where will bond yields go? Will this move by S&P set in motion an avalanche (albeit in slow motion to begin with) that in weeks or months may revoke anyone’s ability (even that of S&P and the other agencies) to manage and control matters, that is, to have CONTROL over when and if the U.S. loses its Aaa rating?

Posted by NukerDoggie | Report as abusive

Think Japan. Still ultra-low borrowing costs, despite what the rating agencies have done.

Posted by GRRR | Report as abusive

America should not have bailed out our rogue financial system because it has resulted in a “debt-to-GDP north of 80%”.

We should follow Iceland’s lead and force the financial industry to absorb its self-created debt.

The pain trouble that would have followed such a move in 2008 is not that different from the trouble that awaits us now, except that it would have been shared by those who created the problem.

That might prevent a reoccurrence of reckless behavior. The MBA’s on Wall Street now have less incentive to act responsibly than they did in the run up to the Collapse.

Posted by breezinthru | Report as abusive

Why does the US government rating act as a sovereign ceiling? I can see the logic with banks, but couldn’t a company have a better rating, I think some Japanese ones do?

[In practice I don't think such a company would be more creditworthy than US govt, but I'm not convinced comparisions make any sense]

Posted by mjturner | Report as abusive

This is just politics, where the management of S&P is trying to bully or embarrass the government into reducing the deficit. Ratings are all relative, so the US needs to be compared to other economies of similar scale. So which ones have no debt problems? Britain? No. The rest of the EU? No. Japan? No. China? Bingo!

In a world where excessive debt is punished by devaluing the underlying currency, the renminbi would appreciate vs. the dollar, and Americans would pay the price for overconsumption. But China refuses to let the market determine the value of the dollar, which they hold so many of, so there are little or no penalties for our monstrous deficits. A downgrade by S&P would expose their irrelevance, which may be a good thing, for as 300sion pointed out, they screwed us all with their worthless bond ratings.

When China floats the renminbi, we can be worried, but only for a short time, as the net result will be factories re-opening in the US. Which is why they are so reluctant to accurately price the dollar.

Posted by KenG_CA | Report as abusive

Had these watchdogs like S&P worked well even to the level of 0.1 on a scale of 10 there would have been no crises like the ones every other conomy is facing today in the first place.
This shows there is most serious need of a credible rating apparatus in today’s world to ward off schockings in future and replace S&Ps like parasites immediately.

Posted by neazs | Report as abusive

S&P is only stating what everyone else in the world already senses. Put this together with what emerging economies had to say recently about “big brother” finances and the IMF, and you can see how our government and the Fed are being percieved. Where is our credibility? Sure China should let it’s currency float. But what about us and our humungous debt? Who’s being irresponsibe?

Posted by 123456951 | Report as abusive

That is Herb Stein, not his moron son. This confusion has propelled the latter’s rise to the top of the idiocracy, and needs to be clarified every time the Stein born with a functioning brain is mentioned.

Posted by maynardGkeynes | Report as abusive

“This is just politics, where the management of S&P is trying to bully or embarrass the government into reducing the deficit. ”

Har har!

Move it along folks, nothing to see here!

Posted by DanHess | Report as abusive

“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.”

I think we might see a rise in what I would call super-soverign corporations. I can think of dozens of very large companies that issue debt in more than one currencies. For them it’s a low risk endevor because they produce profits in the currencies they issue in.

Why could a company like Berkshire not offer a “global bond” in gold ounce units or oil barrel units. You invest 100 units at the current spot price for 10 years at 3% interest (also measured in units.) Then you can pick your favorate currency every time a coupon payment is due. You want pounds you get pounds you want euro you get euro you want $$$ then you get $$$ all based on the price of the underlying index.

Soverigns would hate the idea because bonds like that would be so clearly superior and lower risk to bonds issued in one fiat currency… but investors would LOVE them. I’d bet anything that Berkshire could issue for .25 under the US Goverment with terms like that!

Posted by y2kurtus | Report as abusive

y2k, how many hundreds of billions of dollars worth of bonds could Berkshire issue, every year? Not enough to absorb all the cash that is not being invested in anything and wants to be kept safe.

The dollar can only be replaced by a currency with similar amounts of liquidity, and since all of those except for China have their own debt issues, that leaves only China to start offering bonds. Do you think they could pull that off?

Posted by KenG_CA | Report as abusive

is S&P really concerned about the deficit or the rush to default by not increasing the debt ceiling? after all as many have noted Japan (there is more than double their national GDP) has a much much higher government debt load and seems to have no trouble getting good interest rates? and considering total private debt (consumers and business) is many magnitudes larger that Federal government debt, why isn’t that a larger concern?

Posted by willid3 | Report as abusive

Actually, I could see a scenario develop wherein we have another financial crisis somewhat similar to the last one in 2007-2008, with yet another commodities bubble burst like we had in the summer/fall of 2008. Global wealth has been flowing out of Treasuries and the dollar and into “hard assets” like commodities, just like it was leading up to the fall of 2008. The Fed’s QE2 is a big factor here. So now we’ve got this latest commodities bubble. What happens if something occurs to trigger global investor panic again, and there’s a massive rush into very short-term Treasuries for safety? As several posters here have observed, there’s no place else to park your wealth where you can get the depth and liquidity you need. With S&P and perhaps other agencies soon cutting the medium to longterm outlook for the U.S. (especially if it doesn’t get on the path of getting its house in order very soon), who’s going to pile into anything but the shortest-dated Treasuries? So, then what happens when you get the violent movement of massive sums of global wealth out of commodities and back into the Treasuries markets again? And also out of longer-dated Treasuries into the short-dated ones. The whole global order sees terrific stresses and strains, and it’s much weaker than it was in 2008. It places terrific strains on the U.S. Treasury to have an inordinate percentage of investors piled into shorest-dated Treasuries because of the rollover issues. Bottom line: I could see the entire dollar-denominated bond market break down and crash. Massive loss of wealth. Opportunity for China and Friends to establish a new bond order?

Posted by NukerDoggie | Report as abusive

Does this cast doubt on those economic studies that are based on the assumption that US debt is a risk-free investment? Even if they monetize the debt, as petertemplar persistently insists they might, you can’t get around inflation risk.

Posted by TFF | Report as abusive