Sunday, August 7, 2011 1 comments ++[ CLICK TO COMMENT ]++

Historic downgrade: S&P lowers USA's credit rating from AAA to AA+

Most of you would have heard it by now but I thought I would blog about it because it may turn out to be an historical event in world history. For those that missed it, S&P downgraded USA's sovereign credit rating to AA+ from AAA. This was the first time in history that USA was downgraded from AAA.

I am bullish on USA in the long run but if the view of some skeptics who think USA has peaked turns out to be true, this rating downgrade may be as close to any bell being rung at the top.

Outlook Remains Negative

To add further pain for American taxpayers, who are the issuers of the bonds, it kept the outlook at negative, which is kind of surprising to me. The negative outlook means that S&P may revise down the rating within 2 years. If USA gets cut again, I think it would be more catastrophic. If USA ends up being rated less than AA+ (assuming other rating agencies do something similar), it would create a chaotic situation with USA have signficantly lower rating than mid-tier sovereigns. Presently, the AA+ rating (even if other rating agencies give a similar rating) isn't too bad because it is still an "elite" rating.

I'm not as bearish on USA in the long run as many others but, nevertheless, even I will concede that it is possible that USA may not get back an AAA rating for decades. Canada, for example, was downgraded and recovered its AAA rating by the late 90's but the current problems faced by USA, as well as all the other AAA-rated countries such as Britain, are more difficult than what Canada encountered in the late 80's and 90's.


The impact of S&P's downgrade isn't as damaging as it seems because the other two main rating agencies, Moody's and Fitch, reiterated the AAA rating earlier in the week. USA is in a similar state as New Zealand, if I remember correctly, which is rated AAA by one agency and AA+ by another. Most investors tend to price assets based on the majority of the three rating agencies. Therefore, USA is still AAA-rated for most purposes and I don't expect to see forced selling by funds that are mandated to hold AAA-rated sovereign bonds (or at least overweight AAA bonds relative to other holdings). However, it's still possible bond market participants may re-price the bonds based on signalling inherent in the Standard & Poors action.

Given what is described in the above paragraph, the impact on the US government isn't expected to be significant. Some estimates I have seen suggest that US will have to pay around $100 billion more in interest payments and that isn't that big for such a big country. Given the quasi-deflationary environment that permeates most of the developed world, I'm still not sure if American bond yields will rise any time soon. Credit busts tend to be deflationary and my expectation has been for rates to stay low for many years.

Driven by Politics

I did think that USA's debt may be downgraded in the future but did not expect it to occur right now. I was thinking that other AAA-rated countries with bigger debt loads, lower economic potential, and weaker property rights would be downgraded first, and then USA would get the axe. Surprisingly, it didn't happen that way. There are countries such as Britain, France, and the Netherlands, which I perceive as being way more risky than long-term US government bonds (you can get a list of S&P sovereign ratings here).

The downgrade seems to be largely driven by political considerations rather than economic. If it was purely economic and "earnings power," USA should not be rated below, say, the Netherlands. Yet, it is—at least by S&P. The reasons appear to be political in nature. S&P indicates that it has low faith in the United States government in resolving some of these issues.

My guess is that S&P is undertaking this action to defend the rating industry. Even with the ratings problems from the housing bubble, the industry was under great pressure over the last few months due to the wrangling in the US Congress and Senate over the debt ceiling. The rating agencies were in a tough spot a few weeks ago when it seemed the politicians, and American taxpayers who elect them, wanted to default on some obligations. This caused serious problems for the rating agencies because they still had a AAA rating yet there was open talk from senior politicians about purposely defaulting on some obligations. It was quite surreal to me: here we were with talk about potential default or delayed bond payments (basically a default) yet the bonds were rated AAA. American politicians have always played a game with the debt limit in the past, not passing legislation to increase it until needless last-minute bargaining is complete. However, in the past, USA's fiscal situation was nowhere near as bad as now. USA's debt levels, as well as its ability to pay, were never questioned in the past.

S&P probably took this action to indicate to the US government that they don't want to be in that situation ever again. Although risky—it'll make or break S&P in the long run—the strategy followed by the agency makes sense to me. You don't want to be in a situation where the politicians purposely default when your economic analysis shows the country can pay. In such a case, politics should take precedence over economic ability to pay.

Beyond political considerations, S&P does identify several important events that occurred or are about to. First of all, S&P astutely points out how the downwardly revised GDP numbers for the Q4-2007 to 2Q-2009 period indicate that the economy grew less and, hence, the debt load, as well as the recovery was worse than imagined. Secondly, S&P points out that America's demographics is close to a tipping point—the retirement of baby boomers—and age-related spending may significantly increase.

S&P's Opinion

S&P's new ratings for United States of America:

Long-term sovereign: AA+
Short-term: A-1+
Transfer & Convertibility Assessment: AAA

You can access the full Standard & Poors report here. Let me quote some key opinions from the report (I bolded some items I wanted to highlight):

On Aug. 5, 2011, Standard & Poor's Ratings Services lowered its long-term
sovereign credit rating on the United States of America to 'AA+' from 'AAA'.
The outlook on the long-term rating is negative. At the same time, Standard &
Poor's affirmed its 'A-1+' short-term rating on the U.S. In addition, Standard
& Poor's removed both ratings from CreditWatch, where they were placed on July
14, 2011, with negative implications.

The transfer and convertibility (T&C) assessment of the U.S.--our
assessment of the likelihood of official interference in the ability of
U.S.-based public- and private-sector issuers to secure foreign exchange for
debt service--remains 'AAA'.


We lowered our long-term rating on the U.S. because we believe that the
prolonged controversy over raising the statutory debt ceiling and the related
fiscal policy debate indicate that further near-term progress containing the
growth in public spending, especially on entitlements, or on reaching an
agreement on raising revenues is less likely than we previously assumed and
will remain a contentious and fitful process. We also believe that the fiscal
consolidation plan that Congress and the Administration agreed to this week
falls short of the amount that we believe is necessary to stabilize the
general government debt burden by the middle of the decade.


The political brinksmanship of recent months highlights what we see as
America's governance and policymaking becoming less stable, less effective,
and less predictable than what we previously believed. The statutory debt
ceiling and the threat of default have become political bargaining chips in
the debate over fiscal policy.


Our opinion is that elected officials remain wary of tackling the
structural issues required to effectively address the rising U.S. public debt
burden in a manner consistent with a 'AAA' rating and with 'AAA' rated
sovereign peers (see Sovereign Government Rating Methodology and Assumptions,"
June 30, 2011, especially Paragraphs 36-41). In our view, the difficulty in
framing a consensus on fiscal policy weakens the government's ability to
manage public finances and diverts attention from the debate over how to
achieve more balanced and dynamic economic growth in an era of fiscal
stringency and private-sector deleveraging (ibid). A new political consensus
might (or might not) emerge after the 2012 elections, but we believe that by then, the government debt burden will likely be higher, the needed medium-term
fiscal adjustment potentially greater, and the inflection point on the U.S.
population's demographics and other age-related spending drivers closer at
hand (see "Global Aging 2011: In The U.S., Going Gray Will Likely Cost Even
More Green, Now," June 21, 2011).


Our revised scenarios also take into account the significant negative
revisions to historical GDP data that the Bureau of Economic Analysis
announced on July 29. From our perspective, the effect of these revisions
underscores two related points when evaluating the likely debt trajectory of
the U.S. government. First, the revisions show that the recent recession was
deeper than previously assumed, so the GDP this year is lower than previously
thought in both nominal and real terms. Consequently, the debt burden is
slightly higher. Second, the revised data highlight the sub-par path of the
current economic recovery when compared with rebounds following previous
post-war recessions. We believe the sluggish pace of the current economic
recovery could be consistent with the experiences of countries that have had
financial crises in which the slow process of debt deleveraging in the private
sector leads to a persistent drag on demand. As a result, our downside case
scenario assumes relatively modest real trend GDP growth of 2.5% and inflation
of near 1.5% annually going forward.

(source: "Research Update: United States of America Long-Term Rating Lowered To 'AA+' On Political Risks And Rising Debt Burden; Outlook Negative," Standard & Poors Global Credit Portal, RatingsDirect. August 5, 2011)


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