What *will* you do, S&P? | FT Alphaville

What *will* you do, S&P?

As has been noted everywhere, the debt deal approved by the US House of Representatives on Monday night holds little promise of achieving the $4,000bn in spending cuts that ratings agencies are thought to be wanting. Standard & Poor’s, the agency which put the $4,000bn number out there, has since backed away from it a little, but not in such a way that guarantees they will do nothing, either.

Mohamed El-Erian said on Monday he suspected S&P was “under enormous pressure” not to go ahead with the downgrade. He’s not the only one — S&P’s president, Deven Sharma, was asked about when he appeared before Congress last week (he denied it, of course).

There is certainly no shortage of pundits calling for a downgrade.

See comments like this from Rabobank’s senior US strategist, Philip Marey:

“So unless the rating agencies have a change of heart, and are willing to lose all credibility, a downgrade is unavoidable from here.”

Or this, from boutique brokerage Mogavero, Lee & Co:

“People are saying that the language Standard & Poor’s has been putting out almost requires them to give us a downgrade of some kind.”

There’s more than just S&P’s image at stake. Economists Carmen and Vincent Reinhart argue in the FT that a AA rating is soundly deserved:

In particular, unfinished business lingers from the financial crisis of 2007-09, mostly related to bad mortgages. Those are troubling for those institutions that hold the debt, as well as being a considerable burden for the one in five mortgage owners whose houses are now worth less than their debt.

The voices calling for a downgrade — at least, the ones out in the open — seem to be loudest. So, what will S&P do? Helpfully, after issuing its negative credit outlook in July, the agency pondered three scenarios:

  • Scenario 1–The White House and Congress agree to raise the debt ceiling and collaborate on a long-term framework for fiscal consolidation;
  • Scenario 2–The White House and Congress agree to raise the debt ceiling to avoid potential default but are not able to formulate what we consider to be a realistic and credible fiscal consolidation plan;
  • Scenario 3–The White House and Congress cannot agree to raise the debt ceiling by their Aug. 2 deadline, and the Treasury begins to sharply reduce spending to preserve cash for debt service and to try to keep within the debt ceiling. Such measures could conclude, if the standoff persisted for just a short while, with the Treasury missing an interest payment or failing to pay off maturing debt, i.e. a default.

Obviously we’re going with something in the realm of Scenario 2. Here is how S&P elaborates on what that would mean, and how they might respond:

From a creditworthiness perspective, we believe that failure to formulate a fiscal consolidation plan, even if the president and Congress were to agree to raise the debt ceiling in time to avert a potential default, would be materially less optimal than hypothetical scenario 1. Such a partial solution would essentially put before American voters in the 2012 presidential and congressional election the spending vs. revenue debate. Meanwhile, debt would continue to mount and the results of the election might not, in any event, resolve the issue.

Well, the deal potentially avoids that scenario — one of the few concessions that the Democrats wrung out of the process is a trigger designed to compel the parties to agree further cuts and debt ceiling increases. Of course, whether even that works is anyone’s guess — the parties are already disagreeing over whether tax hikes are really off the table, before the new bipartisan spending cuts committee is even formed.

S&P’s director of sovereign debt division has been quoted as saying that, in contrast to European countries, the problem with the US is “there is no strategy”. Does this somewhat fraught plan constitute a strategy?

Part of the rationale of calls for a downgrade is that it won’t hurt that much. AllianceBernstein researchers, for one, found a AA rating is not the end of the world; it has to get a notch or two lower for things to get really interesting.

But the real problem is, what does the future hold for a country whose political system allows such recklessness? Particularly in the eyes of non-US investors? A Citi note we excerpted last week was fairly blithe about the likelihood of domestic Treasuries owners having to reduce their holdings due to a downgrade. But for foreign holders, it was less positive:

Foreign Official — Central Bank and Sovereign Wealth Funds are likely to modestly sell and modestly reduce future purchases of Treasuries. We think that very few would be forced sellers at the double-A level — although some potentially could be. However, we think that this would forever change the view of US Treasuries as a riskless asset. In practice, this type of an action would likely slightly accelerate the diversification out of US Treasuries into other assets that have been under way for decades.

Other Foreign — We expect that there would be few forced sellers, but more sellers by choice in this category. It is more likely that these investors are in out of benchmark investments and these investors are certainly non US centric. While foreign financial institutions may have many of these securities matched versus US dollar liabilities, many investors are likely to look at other triple-A assets worldwide as a substitute.

Reinhart and Reinhart are also worrying about it:

Such a sub-par performance makes it much harder to overcome America’s balance-sheet problems. These future liabilities also make more palpable the second risk identified by the rating agencies: the fact that almost half of all Treasury securities are now in the hands of foreigners. Here, demand for US debt has increased as emerging markets try to keep their bilateral exchange rates steady. Yet foreign official accounts want to get repaid as much as other investors – and if foreigners focus on the standoff, not the settlement, their doubts may grow about the US’s role in global markets. Any decision to slow foreign exchange intervention would tend to weaken the dollar, while also making the Treasury’s task of funding large budget deficits much more difficult.

Then again — where else will they go?

If/when a downgrade does occur, we should have plenty of time to see the effects play out. As Felix Salmon discovered, once a sovereign loses a AAA rating it often takes a perilously long time to claw it back (Canada, he says, has the record for the longest time in the sub-triple A wilderness, at nine years nine months).

Related links:
Debt downgrade amounts to a few basis points in ratings history – Bloomberg
US economic policy is not yet triple A – Gavyn Davies – FT
Rating (ir)relevance and downgrade speculation – FT Alphaville
S&P’s head of debt ratings: We’re losing faith in the US Government – The Atlantic