The long-term implications of a US downgrade

By Felix Salmon
July 28, 2011
The Economic Word, asks a very good question via email, about the implications of the US losing its triple-A rating:

" data-share-img="" data-share="twitter,facebook,linkedin,reddit,google" data-share-count="true">

David Boucher, of The Economic Word, asks a very good question via email, about the implications of the US losing its triple-A rating:

I was wondering if the state-level impact of a debt downgrade would be different, more severe.

From my understanding, Illinois and California have the two lowest ratings of the US states; if the US were to be downgraded and so would a couple of trouble states, would it have an impact on the ability of the Federal Government to lend a hand to those in trouble? And as a result create a Euro-ish type of debt crisis within the US?

There’s certainly a general understanding, in the markets, that California is too big to fail: if push came to shove, the federal government would bail it out rather than let it default. But David raises a good point: is the moral-hazard trade going to get weakened if the US loses its inviolability?

The way that credit ratings work, any municipalities which currently have triple-A ratings would almost certainly lose those ratings were the US sovereign to be downgraded. As far as I know, there’s no precedent for a sub-sovereign entity to have a higher rating than the sovereign, except in extreme cases where the sovereign is actually in default.

That said, I don’t think there’s much of a trickle-down effect. When you get to states like California or Illinois, which have single-A ratings and are therefore many notches below triple-A already, a downgrade of the sovereign does not mean an automatic downgrade of the state. California and Illinois are being rated on their own merits, or lack thereof — they don’t just have a rating x notches below the sovereign.

So if the sovereign downgrade hurts the likes of California and Illinois, it will be where it hurts, in the markets, rather than immediately in their own credit ratings. There’s some number between 0 and 1 which is the probability of the existence of an implicit federal guarantee on each state’s debt. That number will almost certainly fall when the US gets downgraded. And the lower that number, the more expensive it becomes for either state to borrow money.

When the federal government is strong and can step in to save the day with little harm to itself, it’s wont to do so. But the lesson of countries like Ireland is that you have to be very careful whom you bail out, lest you hurt your own creditworthiness. And the message of the US sovereign downgrade is very much that the government can’t just spend as much money as it likes without worrying about the effect on its own creditworthiness. A bailout of California would be extremely expensive, and would also set a very dangerous precedent for other states which might run into trouble.

The worst effects of a US downgrade, then, might not be felt for years, until the point at which a big state starts running into fiscal difficulties that are so serious that it faces difficulty repaying its bonded debt. At that point, in the olden days, the markets would expect some kind of federal aid; post-downgrade, they might just run chaotically for the exits instead, leaving the state’s citizens holding a bunch of paper worth less than half its face value.

The bottom line is that a US-double-A is a more brittle and fragile place than a US-triple-A: if and when things go wrong, they will go wrong more dramatically and drastically than if the undisputed global hegemon was always understood to have the ability and inclination to smooth things over and sort things out. If bond yields don’t rise much in the wake of a downgrade, don’t for a minute think that means the rating doesn’t matter. It just means that the rating doesn’t matter yet. In extremis, the markets really do care about this kind of thing. And remember too that the first downgrade is always the hardest. Once the ratings agencies have stripped the US of its triple-A rating, they’re going to find it much easier to make subsequent downgrades. There’s a lot of danger associated with a downgrade, even if there doesn’t turn out to be a big and immediate market sell-off.

More From Felix Salmon
Post Felix
The Piketty pessimist
The most expensive lottery ticket in the world
The problems of HFT, Joe Stiglitz edition
Private equity math, Nuveen edition
Five explanations for Greece’s bond yield
Comments
10 comments so far

Felix notes: “The way that credit ratings work, any municipalities which currently have triple-A ratings would almost certainly lose those ratings were the US sovereign to be downgraded. As far as I know, there‚Äôs no precedent for a sub-sovereign entity to have a higher rating than the sovereign, except in extreme cases where the sovereign is actually in default.”

Felix, I generally enjoy your pieces, but I ask you to re-consider that statement in light of the market for “sub-sovereigns” in the US, i.e. municipal bonds.

The way that credit ratings work is that they look to, among other things, the cash flows and collateral, direct and indirect, available to pay the off the bond obligation.

Sub-sovereigns in the U.S. come in two flavors generally: revenue bonds and general obligation bonds.

In the case of municipal revenue bonds, these are almost always analyzed much like private corporations, and like private corporations, sometimes need enhancements from insurance companies and/or treasuries in escrow or pre-refunded amounts to gain a higher credit rating.

But there are cases in which revenue bonds stand on their own. For example, a to-be issued bond (Official Statement dated July 21, 2011) by the Town of Hempstead (Nassau County, NY) is supported by property tax revenues. It is listed to be issued with a AAA rating in August 2011 and the risk factor section does not even mention a US federal default or downgrade as a risk. Hempstead gets only 15% of its funds from NY State aid and notes that it would not be materially affected if this were interrupted. Hempstead’s ability to repay is very disconnected from a US federal downgrade or even a US default. Hempstead might actually retain its AAA rating, at the time US federal debt is downgraded.

The same analysis applies to general obligation bonds, with a view to comparing state/municipal/local tax revenues versus state/municipal/local expenses. Analysts also look at the issuing entity’s reliance on federal aid as well as the issuing entity’s needs for credit enhancement mechanisms.

In essence, with sub-sovereigns in the US, you have to think of the US federal government almost the way we think of bond insurers (Ambac, FGIC, etc): their guarantees and enhancements were used to raise the bond’s credit rating but now they really don’t help much.

In other words, sub-sovereign US risk (revenues and GOs) pretty much have to stand on their own in front of the rating agencies. Only if there is a direct or indirect over-reliance on US federal government support will they be downgraded in tandem with the US federal debt.

Which means that there is a very real possibility that if the US debt is downgraded, you will see US municipalities with AAA ratings while the US will sport a lower rating.

Posted by AABender1 | Report as abusive

I think the short term (1 to 2 month or less) consequence of short term default is so much better than the long term consequence of delaying action (moving nearly 2 trillion a year further in the hole), that shutting down the govt and defaulting would be better in the medium to long term.

If I was Boehner I would pass my bill and recess the house for a few days.

Posted by fsdjklfasd | Report as abusive

Even if the US is not downgraded, the lack of confidence in the US is apparent from here on out. Congress is so bogged down in party Politics as usual that it has basically become ineffective. Nobody now expects any long term solutions to come from their legislation. We will be lucky for them to even agree on a deficit ceiling increase.
The problem is the extreme party side voters have voted in far left and right wing politicians who won’t budge on their view on how Government should run. This has caused disagreement even within parties in Congress. I so no end in sight for this unless these extreme views begin to see the damage they are causing to the US.

Posted by jscott418 | Report as abusive

Agree with AABender1′s critique, always good to check the facts before you take a sip of your soda. The muni dimension of the current situation is more relevant to the debt/fiscal discussions rather than rating implications as it would affect fiscal transfers to the states in the short term. For everything else, I don’t think there is any reason to panic – people who are not positioned correctly will lose quite a bit of money, there will be some reshuffling among business and political elites but in the longer term a sharp fiscal contraction will delever the economy, and raise rates and inflation to more normal levels.

Posted by Tseko | Report as abusive

The govt imposed an artificial debt limit on itself, then proceeded to spend at an exhorbitant rate. Now, the politicians are trying to sway the public in an election year over what either side is going to do about it. Kind of like when my college age daughter calls to let me know she is out of money, and if I could just give her a little more, she promises to be more careful in the future. NOT!. The debt limit should not be raised, all that will happen is that the govt will spend right up to it then ask for more. The U.S. should already be downgraded anyway, since we have become a nation of whining dependants, druggos and slackers, with half of us not paying income tax at all, waiting for the next handout from Barry. Not what I want to “invest” in!

Posted by zotdoc | Report as abusive

The govt imposed an artificial debt limit on itself, then proceeded to spend at an exhorbitant rate. Now, the politicians are trying to sway the public in an election year over what either side is going to do about it. Kind of like when my college age daughter calls to let me know she is out of money, and if I could just give her a little more, she promises to be more careful in the future. NOT!. The debt limit should not be raised, all that will happen is that the govt will spend right up to it then ask for more. The U.S. should already be downgraded anyway, since we have become a nation of whining dependants, druggos and slackers, with half of us not paying income tax at all, waiting for the next handout from Barry. Not what I want to “invest” in!

Posted by zotdoc | Report as abusive

I think if the US bails out California, then California should loose their votes in congress until they can pay the Federal Government back. Same for Illinois.

Posted by carterbenb | Report as abusive

I think most people would have considered NYC too big to fail, yet that’s exactly what happened circa 1975. A lot of people who had a vested interest in maintaining the status quo were really annoyed (“US to New York: Drop Dead”), but it seems to have gotten through just fine. Extending that argument, you haven’t demonstrated how California is too big to fail.

Posted by Curmudgeon | Report as abusive

WSJ July 29, 2011
http://online.wsj.com/article/SB10001424 053111904800304576476171358955618.html?m od=WSJ_hp_MIDDLENexttoWhatsNewsThird

Muni-Pricing Services Brace for Downgrade

“We feel pretty confident that we’re going to be able to keep up if this happens next week,” said Frank Dos Santos, vice president at Standard & Poor’s Securities Evaluations, which provides independent valuations for a variety of investments, including government and municipal bonds.

Mr. Dos Santos expects a downgrade to make prices more volatile. While a downgrade would be unprecedented, he compares it to the fall of some so-called monoline insurers of bonds in 2008, which stirred deep uncertainty in the market. “We kind of look at this as being a similar scenario,” he said.

Posted by AABender1 | Report as abusive

Let us start thinking positively,guys.The world is large enough to create business opportunities if one side sinks, the oppposite would happen on the other which will lift it.Any downturn would create upturn ib the economic cycle.It is elasticity of the economy that keeps on going

Posted by RAMMO | Report as abusive
Post Your Comment

We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see http://blogs.reuters.com/fulldisclosure/2010/09/27/toward-a-more-thoughtful-conversation-on-stories/