What S&P's Warning On U.S. Debt Means

By Stephen D. Simpson, CFA | April 28, 2011 AAA

Standard & Poor's rattled the global financial markets and riled up the U.S. political forces in April when it revised its outlook for U.S. government debt to negative. Though not technically a downgrade - U.S. debt still carries an AAA rating - this was a clear and explicit warning by the ratings agency that the U.S. must get its financial house in order or face a downgrade within two years. (Despite investor distrust, rating agencies can be helpful. Just be sure you use these ratings as a starting point, not an endpoint. Find out more in Bond Rating Agencies: Can You Trust Them?)

While not the first time that the United States' rating has had a negative outlook (it happened in 1995-96 as well), it adds another element to already heated debate about the state of the country's budget deficit and outstanding debt burden. What's more, the news was enough to spook stock investors and encourage holders of hard assets like gold and silver.

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What Happens If There's a Downgrade?
If the U.S. loses its AAA rating, the most likely near-term impact would be higher rates on U.S. debt. Given that U.S. government debt underpins many other interest rates, it would not be unreasonable to assume that there would be a widespread increase in rates across many other kinds of debt. Higher rates would not change the interest that bondholders receive (unless they hold adjustable-rate debt), but they would find that the price of those bonds would decline.

Making matters potentially worse, roughly half of the outstanding government bonds are held overseas and are often thought of nearly risk-free assets (or at least as near to risk-free as is attainable in the market). A downgrade, then, would force many holders to reevaluate their portfolios and consider selling some of those bonds, adding further pressure to bond prices (and raising rates).

Along similar lines, long-term U.S. government bonds are often used as the proxy for the risk-free rate in asset pricing models. Higher Treasury rates would then lead directly to higher discount rates, and that would reduce the fair value estimates of equities across the board.

More Legs for Hard Assets
A U.S. debt downgrade would likely fire up precious metals all over again. Precious metals are a preferred method of offsetting the risks of inflation and uncertainty. While the higher rates that would come from a debt downgrade do not necessarily mean inflation, there would certainly be added worry and uncertainty. Given that gold's advocates regard it as an unassailable and untainted global asset, the downgrade of U.S. debt would only serve to highlight this point.

On the flip side, the outlook for the U.S. dollar would be less certain. Buying U.S. Treasury debt requires U.S. currency, so it would stand to reason that any rush to sell U.S. bonds would weaken the currency - to say nothing of the impact on the impression it would give about the health and strength of the United States. On the other hand, higher rates have often led to yield-shopping in other markets, so downgraded Treasuries could counter-intuitively become more attractive to some investors, and that could give some support to the dollar.

Knock-On Effects
If the U.S. loses its AAA rating, there are others who stand to lose. It is hard (and relatively rare) for banks and other financial companies to retain better ratings than their nations, largely because banks are typically such large holders of national debt and because they rely so much upon debt. Consequently, banks and insurance company stocks would likely come under pressure, at least in the short-run.

A U.S. downgrade would also very likely have a significant impact on debt and obligations backed by the federal government. That means that debt issued by organizations like Fannie Mae, Freddie Mac and the FHLB would likewise come under pressure.

The Solution Could Be Painful
With the S&P's warning out there, it is now on the U.S. Congress and Obama administration to figure out workable debt and deficit reduction plans. It is perhaps ironic that the effects of what will be needed to avoid a debt downgrade may end up being more directly painful for some people than the actual downgrade would be.

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The U.S. problem is fairly straightforward: spending is far in excess of what the economic and financial system can maintain for the long term. The solution is likewise relatively straightforward - cut spending and/or raise taxes.

Straightforward does not necessarily mean easy or palatable, however. Entitlement spending is likely to get intense scrutiny and there may well be attempts to introduce means testing or more stringent qualifications like later retirement ages for full Social Security benefits. At the same time, higher taxes will clearly impact the economy and impose a deadweight loss on consumers and businesses. All of that said, those alternatives are more palatable than simply monetizing the debt and using inflation as a dubious solution. (Lack of competition and potential conflicts of interest have called the value of these ratings into question. See The Debt Ratings Debate.)

Possibly Avoidable and Certainly Survivable
There is still time for the U.S. to get its fiscal house in order and stave off a ratings downgrade. Other Western nations have found themselves in bad spots and managed to recover with through discipline, sacrifice and tough choices. Consequently, a downgrade is far from certain so long as Washington takes action and the public is willing to support it.

On the other hand, readers should not assume that a downgrade would be a terrible or economically crippling even. Japan has seen its debt downgraded and the country still enjoys low interest rates. Though this is a partially misleading example - the Japanese people hold a large amount of Japanese debt and that pool of buying power keeps rates low - the reality is that many Western nations have encountered sovereign downgrades without widespread economic chaos or carnage.

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