CQ TODAY ONLINE NEWS – BUDGET
Aug. 6, 2011 – 5:10 p.m.
What Does the S&P Downgrade Mean?
By John Cranford, CQ Staff
Standard & Poor’s, the largest credit rating company in the world, downgraded longer-term debt issued by the U.S. Treasury by one notch on Friday, to AA-plus from AAA. The company retained its highest rating on short-term Treasury securities.
As its reason, S&P cited two factors. It said the difficult political climate in Washington has an adverse effect on decisions regarding the federal debt limit and fiscal policy. And it said efforts to control the growth of the federal debt have been insufficient.
Unless Congress and the president take additional steps to reduce borrowing, S&P warned it might reduce the rating on Treasury securities by another notch.
Following is a series of questions and answers about the credit rating companies and their role:
• What are the factors that go into the debt ratings?
Credit ratings are intended for one purpose: to tell investors whether a particular bond issue, or a particular borrower, is likely to repay its debts or to default. Ratings are designed as a sliding scale to indicate the likelihood of default. In that case, Standard & Poor’s rating suggests that the United States is only slightly more likely to default on longer term securities now than before the downgrade, when the expectation of default was essentially non-existent. S&P’s rating still suggests there is essentially no chance of a default on short-term debt.
• What is Standard & Poor’s and how did it come to be one of the top rating companies?
Standard & Poor’s is one of several companies that have established themselves as arbiters of the creditworthiness of borrowers. They all make money by charging debt-issuers for ratings. S&P, a subsidiary of McGraw Hill Companies Inc., has been in this business for more than a century, and is by far the largest. It rates the debt of hundreds of corporations, cities, counties and states, usually under contract. It rates the debt of 126 countries, but in the case of many, such as the United States, it issues ratings because it chooses to do so. The United States does not ask for a rating, and it does not pay for one.
• Why are some people, including the Obama administration, questioning the validity of the S&P rating?
Many people, including market analysts and economists, disagree that the U.S. government is any more likely to default today than ever, and point to the fact that in a very fractious political environment, the debt-limit and deficit-reduction law ( PL 112-25 ) did get enacted. The Obama administration argued with S&P that the company had miscalculated the level of debt the federal government might expect in the near future, but S&P disagreed. Mostly, the White House has ignored S&P’s complaint that political dysfunction contributes to a sense that a future default is more likely.
• Why is S&P’s rating of U.S. debt different than those of Moody’s and Fitch?
Moody’s Investors Service, the second-largest rating company, has said it was worried the debt limit would not be increased and that it was also concerned that the federal government was not making progress to get its fiscal house in order. Both Moody’s and Fitch Ratings, which is No. 3, said they judged the action by Congress and the White House on the debt limit and deficit reduction to signify sufficient progress, and as a result said they would maintain their top ratings on Treasury debt.
• S&P said the deficit-reduction agreement enacted into law last week was insufficient. Did it suggest that Congress should have cut more or raised taxes?
What Does the S&P Downgrade Mean?
Mostly, S&P concentrated on the political environment, which it criticized, saying future fiscal policy debates would probably “remain a contentious and fitful process.” S&P did say one concern was that there was no agreement between the political parties on either increasing revenue or cutting entitlement spending. But it did not suggest either as a preferred course of action.
• At least one lawmaker has said that Congress should return to Washington in light of S&P’s action. But what could Congress do?
If Congress decided to return early from its August recess, presumably it would kick-start the work of the Joint Select Committee on Deficit Reduction that was created by the law enacted last week, and which by Thanksgiving is supposed to complete a plan to reduce the deficit by an additional $1.2 trillion over 10 years. There are no signs that lawmakers are contemplating a return before Labor Day, however.
• How will we know whether the lower rating on long-term Treasury securities increases the cost to the federal government and others of borrowing money?
The first real signs will come in financial market trading, beginning in Asia on Aug. 8. A clearer indication may come mid-week. Treasury will auction $72 billion in longer term debt on Aug. 9, 10 and 11. If the demand for those securities remains high and investors accept low interest rates close to those currently in effect, it would be a sign that the S&P downgrade is having a limited effect. If demand is down, and interest rates rise, that would suggest that investors are taking the downgrade seriously.
• China, the biggest foreign holder of U.S. government debt, issued another statement Saturday saying the United States needs to live within its means. Will the downgraded rating affect China’s willingness to hold U.S. debt?
China has been arguing for some time that the dollar should not be the world’s “reserve currency,” and that the euro and other currencies have value as indicators of the state of the global economy. So far, that demand has not led China to reduce its purchases of Treasury securities.
• What about other holders and potential buyers of U.S. debt? Will they continue to accept historically low interest rates in light of continuing global economic uncertainty?
Maybe yes and maybe no. Financial market trading and future bond auctions will be the best indicators of this.
• The rating companies have lost credibility over the past few years as a result of their overly optimistic ratings of securities backed by subprime mortgages. Is there reason to believe that S&P is overcompensating in this case?
Some critics of the rating companies say that they should not even be in the business of rating countries because they have no expertise that ordinary investors do not have to assess the creditworthiness of the United States, or many other countries. S&P disagrees and says that it provides a valuable service, while noting that investors will ultimately make their own decisions based on a variety of factors, including ratings.
• Did Congress change the role the rating companies play in financial market regulation as a result of the subprime meltdown, and did that play into S&P’s downgrade?
One of the only bits of bipartisan agreement in the Dodd-Frank financial regulation overhaul ( PL 111-203 ) enacted last year was to downplay credit ratings. The law requires regulatory agencies to remove all references to credit ratings in making judgments about the strength of banks and other regulated financial companies. The rating companies were never regulators in their own right, but now they are not even supposed to influence the judgments of official regulators.