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As Deficit Talks Stall, U.S. Downgrade Looms

Source: WSJ - Tom Lauricella, Matt Phillips

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Posted on 26 Jul 2011

The prospect of a downgrade of the U.S.'s triple-A credit rating, which it has held for nearly a century, has the financial markets worried. This as a result of Republicans and Democrats moving even further apart as they push separate plans for reducing the nation's deficit and raising its borrowing limit.

President Barack Obama warned in a televised prime-time speech that with no clear resolution in sight in Congress, the U.S. government is on the brink of a default that could deeply damage the economy.

"For the first time in history, our country's triple-A credit rating would be downgraded, leaving investors around the world to wonder whether the United States is still a good bet," he said.

House Republican Speaker John Boehner responded to the speech by reasserting his plan to avoid default, saying the president's approach was essentially a "we spend more, you pay more" philosophy.

Mr. Boehner and Senate Majority Leader Harry Reid earlier on Monday launched competing sales pitches for their separate plans, with the Aug. 2 deadline for a potential U.S. default on its debts little more than a week away.

Rep. Boehner (R., Ohio) briefed Republican lawmakers on his two-phase plan to trim as much as $3 trillion from the U.S. deficit and lift the debt ceiling.

Sen. Reid (D., Nev.) unveiled his separate plan for $2.7 trillion in spending cuts over 10 years, a plan that would include a debt-ceiling increase sufficient to carry the government through the end of 2012 and no increase in tax revenue.

Despite the last-minute maneuvering, investors believe officials in Washington will find a way to reach an agreement that allows the government to keep paying its debts. But some worry that any deal might not be enough to stave off a downgrade.

Moody's Investors Service, Standard & Poor's and Fitch Ratings have all warned they might cut the U.S. credit rating. S&P, in particular, has said it could move even if a debt-reduction deal is met and the $14.29 trillion federal debt ceiling is raised.

S&P has cited $4 trillion in debt reduction as a figure that would be appropriate for keeping the triple-A rating. S&P has also said it wants a credible agreement, meaning one that has bipartisan support.

Neither side is close to a $4 trillion figure. And given the wrangling, the chances of strong bipartisan support for any deal seem unlikely, investors said.

President Obama in his speech said that "a six-month extension of the debt ceiling"—similar to the Boehner plan's first phase—"might not be enough to avoid a credit downgrade."

The possibility of a downgrade and its implications became a heavy topic of discussion among Wall Street analysts earlier Monday. "We have gone past the point of no return regarding the debt downgrade. We fully expect the U.S. will lose its AAA status," wrote analysts at Faros Trading.

Brett Rose, head of U.S. rates strategy at Citigroup Global Markets, said, "On Friday, I said it was 50-50" there would be a downgrade. "Given the lack of progress over the weekend, I would say it's even higher now."

Spokesmen for S&P, Moody's and Fitch declined to comment.

Until recently, financial markets consistently shrugged off the debt-ceiling fight as distracting political theater. Yields on U.S. Treasurys remain low by historic standards, suggesting a still-robust investor demand for them, but some signs of concern are beginning to bubble. The yield gap between longest-maturity Treasury bonds, which are highly sensitive to fiscal concerns, and the rest of the Treasurys market has widened.

Yields on one-month Treasury bills also have risen. These assets are seen by some to be at risk since they mature in August, when the Treasury could have difficulty meeting obligations if the limit on federal borrowing isn't raised.

Stocks slid Monday, with the Dow Jones Industrial Average losing 88.36 points, or 0.70% to 12592.80. On Tuesday morning, Asian stock markets opened flat or slightly higher and stayed in the black after the Obama and Boehner speeches.

The loss of a triple-A rating, while unlikely to wreak the sort of havoc akin to a default, could lead to a knee-jerk sell-off in stocks, Treasury securities and the dollar.

Gold, already in record territory, could rally further. Banks and insurers, effectively backstopped by the U.S. government, could also face downgrades and find it more costly to borrow money. U.S. agencies such as Fannie Mae and Freddie Mac could also be downgraded. Moody's says about 7,000 municipal ratings could be cut.

The ratings firms, criticized for giving rosy ratings to subprime-mortgage debt before its collapse, have found themselves again in the middle of a potential debt crisis. They have been downgrading debt of European peripheral nations and have spoken out about the need for the U.S. to reduce its deficit.

A top S&P official met with lawmakers in a private meeting on Capitol Hill last week and said the firm could move to downgrade U.S. debt by early next month. While both S&P and Moody's are often in contact with the Treasury and Congress, their threats are drawing high levels of concern from lawmakers and administration officials.

The issues could come into sharper focus on Wednesday, when a House subcommittee holds a hearing on the rating agencies and top company officials are expected to testify.

The ratings agencies are playing such a large role in part because so many mutual funds, pension funds and banks, as well as regulators, use the ratings as a benchmark for setting rules and guidelines for investing. Many have long regarded triple-A-rated Treasurys as essentially "risk free." Any change to that could have broad ramifications for the way they invest and lend.

Some could prove short-lived, but there might be lingering negative effects in the form of higher borrowing costs for an economy already struggling to pay down debt. A downgrade could further spook already-nervous individual investors or foreign investors the U.S. government depends on to borrow.

Many investors believe that S&P, based on its public statements, is the most likely of the agencies to downgrade the U.S. In recent days, the chairman of S&P's sovereign-ratings committee, John Chambers, has been meeting with some of the world's biggest bond-fund managers. On Thursday, he visited Pacific Investment Management Co., known as Pimco, for a session dominated by a discussion about a possible downgrade.

The day before, he visited Legg Mason Inc.'s Western Asset Management, which manages $455 billion. Mr. Chambers met with some of the firm's senior investment professionals, and in their view, reinforced the notion that a downgrade was a real possibility. "We came out unambiguous that the odds were much higher than 50-50," said a person familiar with the meeting.

A group of 14 large investors, including BlackRock Inc., Legg Mason and pension plans in North Carolina and Florida, formed a coalition, writing an open letter to President Obama and Congress urging a quick resolution to the deficit gridlock.

The notion that the U.S. could be downgraded has strategists and analysts wrestling with what the impact might be. Some say 10-year Treasury yields might rise to 3.5% from 3%, a significant move but still a low rate.

Massive selling of Treasurys is considered unlikely; a downgrade is thought unlikely to force money-market funds or other holders to sell. Banks and insurers, though, likely would be forced to add more capital to support their portfolios, and borrowing costs in general probably would rise, investors said.

CME Group Inc. told traders late Monday that as of Thursday they would need to post more Treasurys when using them as collateral for futures trading, responding to rising volatility in Treasury markets.

Any move higher in rates caused by a downgrade would slow the already-soft economy and keep the Federal Reserve from raising interest rates, said Kathy Jones, fixed income strategist at Charles Schwab.

President Obama said that without a resolution, "We would risk sparking a deep economic crisis—one caused almost entirely by Washington."


Comments

 
Robert Pfeffer  Jul 27 2011 6:34AM Report Abuse
Congress and this President has been on a spending spree for as long as I can remember. This President wants to "BLAME IT ON BUSH" but as much as I think Bush did not do a great job he did keep this country from being hit again and yes that cost money and drove up the debt. That being said too much of the debt is the direct result of all the "PORK" AND THE POSTURING FOR VOTES TO GET ELECTED.We need a balance budget amendment and term limits. Senate two six year terns House six two year terms to match the senate term. Govement is not camelot and we have to change the lords of govement to give the people what our founding fathers wanted :govt. by the people for the people".
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