S & P Downgrades U.S. Debt – Investors Remain Nervous

 

On Friday, August 5, 2011, Standard & Poors, one of the three major credit rating agencies, downgraded U.S. Treasury obligations for the first time ever. The new grade is AA+, one notch below the highest AAA rating. The other two major ratings agencies, Moody’s and Fitch, have not announced a downgrade of U.S. debt at this time. Upon the announcement, investors heavily sold Treasuries, which dropped sharply sending yields higher.

Standard & Poors said the reasons behind this historic step were: (1) lack of effectiveness, stability and predictability of the President and Congress in dealing with the present fiscal and economic challenges, and (2) the agreement to raise the debt ceiling with no credible agreement to reduce debt in the medium term. In other words, political dysfunction in Washington precipitated the downgrade.

But talk of political dysfunction may simply be masking the enormity of the structural problems presented by the entitlement, defense and other mandatory spending that makes up about 80% of the federal budget. Even if everyone agreed to do it, can that spending be significantly cut or enough tax revenue raised without causing even more damage to the economy and national security?

Though dramatic, the downgrade was not a bolt out of the blue. Standard & Poors had previously issued a series of warnings, including placing the U.S. credit rating on “negative watch,” meaning that a downgrade will occur absent some change of course that causes it to revise its view that a downgrade is appropriate.

Some have said the impact will be modest and the downgrade is only symbolic. This view seems to be based largely on Moody’s and Fitch not having issued a downgrade, and the apparent fact that U.S. Treasuries are still the safest investment in the world, and, since there is no other competing “safe haven,” buying will balance selling and keep yields low.

But the downgrade is more than symbolic. There will be fallout. The ultimate impact is unknown but there can be no doubt that ripple effects will occur. Indeed, Standard & Poors reportedly said it would “issue separate releases concerning affected ratings in the funds, government-related entities, financial institutions, insurance, public finance, and structured finance sectors.” A couple of weeks ago, Standard & Poors was quoted as saying: “We assume that under this scenario [i.e., downgrading U.S. debt to AA+] we would see a moderate rise in long-term interest rates (25-50 basis points), despite an accommodative Fed, due to an ebbing of market confidence, as well as some slowing of economic growth (25-50 basis points on GDP growth) amid an increase in consumer and business caution.”

Among those likely suffer immediate follow-up downgrades, according to Standard & Poors, are: Fannie Mae, Freddie Mac, Federal Home Loan Banks, Federal Farm Credit System Banks, U.S. insurance groups, the Army & Air Force Exchange Service, the Marine Corps Community Services, and the Navy Exchange Command.

For structured finance transactions, Standard & Poors said it will assess the degree of each deal’s exposure to U.S. government obligations or guarantees, and lower the ratings accordingly.

Page Perry is an Atlanta-based law firm with over 125 years collective experience representing investors in securities-related litigation and arbitration. While past results are not indicative of future success, Page Perry’s attorneys have recovered over $1,000,000 for clients on more than 45 occasions.