Next move on U.S. credit rating? ‘D’ for default

S&P warns of dire consequences

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Despite expressing confidence that the U.S. will avoid a default, one top credit rating agency has issued a quiet warning that the nation’s AA+ rating will plunge suddenly to a shockingly low D if a political resolution does not come in time to prevent the Treasury from missing a debt payment in the next month.

Standard & Poor’s Corp., the oldest Wall Street rating firm and the same one that previously triggered a global market rout in August 2011 by being the first to downgrade the U.S. from AAA, is now saying the next step for the U.S. will not be another minor notch down, as occurred last time, but rather be more like falling off the cliff altogether.

Its casual and unpublicized warning, buried deep in an explainer on the government shutdown, underscores how unexpected and even unthinkable dangers lurk in the background as the Congress and the White House flirt with allowing the Treasury to run out of borrowing room this week.

Various proposals to forestall default at least for a few weeks have emerged in Congress, though none appears to have the votes to pass. The fervent last-minute efforts by congressional leaders ahead of Thursday’s “drop dead” deadline laid down by the Treasury illustrate why S&P and other rating agencies say they are confident that the Treasury will be rescued from default through an eleventh-hour deal.

But any short-term deal would only postpone the day of reckoning on the debt while setting up another deadline and likely political confrontation later this year or next.

S&P’s quiet warning likely influenced the administration and lawmakers to finally start negotiations on Friday. Markets reacted violently to S&P’s first, more minor downgrade in 2011, with the Dow Jones industrial average plummeting by more than 1,000 points. The wholesale collapse of the U.S. rating being suggested by S&P this time around, after earning what was once the highest rating of any government on Earth, is not something most investors have prepared for or even contemplated could ever happen.

But the Treasury and many analysts are pointing out that the margin for error grows so thin once the Treasury exhausts its borrowing authority that a minor mistake or miscalculation by Congress or Treasury’s bean-counters — say on figuring how much cash they have on hand to make a scheduled debt payment — could plunge the nation into an accidental slip-up with calamitous consequences for the global economy and financial markets.

Monumental miscalculation?

Treasury Secretary Jack Lew highlighted the potential for a monumental miscalculation, one that could be precipitated by outside investors, in testimony before Congress on Thursday. He noted that even when the Treasury has exhausted its authority to borrow above the current limit, it must continue to roll over or refinance $100 billion of existing U.S. Treasury bills each week.

“We are relying on investors from all over the world to continue to hold U.S. bonds,” he said. Nations such as China and Japan are given the opportunity to keep buying bonds each week, but they also may choose to sell them. Already some investors are starting to shun them out of concern about a default, causing the rates on short-term notes to rise. “If U.S. bond holders decided that they wanted to be repaid rather than continuing to roll over their Treasury investments, we could unexpectedly dissipate our entire cash balance” and be forced into default within days, Mr. Lew said.

“Make no mistake — unintended consequences do occur and much more frequently than most are willing to admit,” said investment analyst Joseph Stuber, who thinks the odds of the U.S. stumbling into a default are high. “Recessions are almost always caused by miscalculations on the consequence of a particular policy and/or regulatory action/blunder.”

S&P’s warning fuels the worst fears. The agency has not issued a formal warning of a downgrade, as it says the current impasse has a 2-in-3 chance of being resolved at the last minute like previous ones, in time to permit timely payments by the Treasury.

But should the 1-in-3 chance of a U.S. default actually occur, S&P credit analyst Marie Cavanaugh stressed that the Treasury will be treated like any other bond issuer and will not be accorded any special treatment despite the U.S. status as the pre-eminent global bond market and safe haven for investments for nearly a century.

“Should the government fail to service a debt obligation, we would lower the sovereign rating to ‘SD’ [selective default],” she said, adding that such a sharp downgrade would not be temporary and most likely would lead to a permanent and severe downsizing of U.S. credit prospects. “The rating would remain at ‘SD’ until the default is cured, which may occur when delinquent principal and interest payments are paid in full,” she said. Thereafter, the S&P usually gives any governments that have gone into default junk ratings in the CCC+ to B range, although she suggested the U.S. rating might be somewhat higher because the default likely would occur for political reasons, rather than the usual financial ones.

Loss of status looms

S&P is not the only agency that rates the U.S. The country still gets a AAA rating from Fitch Ratings and Moody’s Investors Service, Wall Street’s other two top agencies. But it would be impossible for the financial markets to ignore the massive downgrade contemplated by S&P.

In one fell swoop, as the result of a mere accident or misstep, the U.S. could go from being the top-rated and most sought after investment in the world to being one of the lowest-rated major economies, a loss of status that almost certainly would make it far more difficult for the U.S. to finance its huge deficits and tarnish the reserve status of the U.S. dollar for decades to come.

That is why the Treasury and various Wall Street institutions have issued such dire warnings about the potentially catastrophic effects from a default, no matter how temporary or minor it may seem to the average American.

Pension funds, mutual funds and other big institutions would be forced to divest their Treasury holdings, in what would be only the beginning of a chaotic reordering of global markets where trillions of dollars of loans and other instruments are backed by Treasury bonds or otherwise tied to benchmark U.S. securities.

Virtually all U.S. interest rates, from 30-year mortgages to credit cards, are linked directly or indirectly to the rates on Treasuries.

The business and financial world has been nearly unanimous in warning political leaders against even a minor or technical default in recent days. Major business groups from the U.S. Chamber of Commerce to the National Retail Federation and National Association of Manufacturers have warned Congress that it must act in time.

In a glimpse of the potential devastation in just one sector, a survey by the Association for Financial Professionals this month found that one-sixth of U.S. corporations currently holding Treasury securities would shift out of most or all of those investments if the debt ceiling isn’t raised in time. Another 36 percent would hold onto their current holdings of Treasuries, but would not purchase these securities going forward.

“Companies are issuing a warning,” said association President Jim Kaitz. “Financial executives see dire consequences to prolonged political theater in Washington and a potential U.S. government default.”

While Standard & Poor’s is being unusually explicit in outlining the consequences of a missed payment by the Treasury, Moody’s Investors Service — which continues to give Treasury a coveted AAA rating — has been unusually silent.

The agency went out on a limb this summer and declared that there was little chance of a downgrade this year because of the nation’s fast-declining budget deficits and the seeming political truce reached between Republicans and Democrats over raising the debt limit at the beginning of the year after they adopted legislation addressing the “fiscal cliff.”

The frantic, last-minute negotations aimed at averting a default give fuel to Moody’s optimism. But even if the Treasury does run out of room for additional borrowing — whether after Oct. 17 or some later date — Moody’s expects it would manage to keep paying interest on the debt at least for a while longer. Without a debt limit increase before Oct. 17, for example, Moody’s calculates that the big crunch wouldn’t come until Nov. 15, when the Treasury has an unusually large interest payment of $31 billion coming due and likely would not have enough cash on hand to make it.

Moody’s optimism also is based on the assumption that the Treasury would withhold payment on other U.S. obligations, such as paying Social Security, Medicare and veterans benefits, so it can conserve cash and honor its debt payments. The Treasury has denied it has authority to pay some obligations but not others that come due. Mr. Lew testified that essentially all the government’s obligation are “at risk” once it runs out of borrowing authority.

Some Wall Street analysts question Moody’s sunny outlook, noting that the agency also seemed confident earlier this month that a government shutdown either would not occur or would be short-lived. They say the credit gurus appear to have been taken by surprise by the intensity and length of the latest impasse, raising the possibility that global markets could be shaken violently by a sudden and unexpected downgrade by Moody’s, S&P or Fitch once they are jolted back to reality.

If Moody’s is being complacent about the potential for a prolonged political impasse or slip-ups at the Treasury, it is not the only one on Wall Street.

“I don’t buy the Armageddon talk,” said Christopher Mahoney, a retired Wall Street banker who once worked for Moody’s and whose sentiments are widely shared among investors. He and other investors are soothed by House Speaker John Boehner’s repeated assurances that he will not allow the nation to default.

“Only a reckless fool would allow the U.S. to default, and I trust that Speaker Boehner is not a reckless fool,” Mr. Mahoney said. He added that even if a default does occur, “it would be survivable, like a dirty bomb or another 9/11,” because investors would understand that it was just a political accident with limited implications for the global markets.

 

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