What Happens After the Credit Downgrade?

Illustration for article titled What Happens After the Credit Downgrade?

On Friday the U.S. ratings agency Standard & Poor's slapped the United States with a downgrade, demoting the country from a top-notch AAA credit rating to AA+. Although the nation's other two major agencies, Moody's Investor Service and Fitch Ratings, reaffirmed the United States' AAA credit rating, S&P's move triggered fear through the stock market, which on Monday had its worst day since the 2008 financial crisis.


S&P took further action on Monday, downgrading to AA+ the credit ratings of Fannie Mae, Freddie Mac and other entities linked to long-term U.S. debt.

In a statement Friday outlining their reasoning, S&P cited a shaky political climate in Washington, D.C., that nearly caused the country to default on its loans, the fact that $2 trillion in spending cuts under the final debt-ceiling/budget deal fall short of the $4 trillion needed to actually lower deficits in coming years and the refusal from congressional Republicans to raise tax revenues. Some excerpts:

"We lowered our long-term rating on the U.S. because we believe that the prolonged controversy over raising the statutory debt ceiling and the related fiscal policy debate indicate that further near-term progress containing the growth in public spending, especially on entitlements, or on reaching an agreement on raising revenues is less likely than we previously assumed and will remain a contentious and fitful process.

" … The political brinksmanship of recent months highlights what we see as America's governance and policymaking becoming less stable, less effective, and less predictable than what we previously believed. The statutory debt ceiling and the threat of default have become political bargaining chips in the debate over fiscal policy.

" … Compared with previous projections, our revised base case scenario now assumes that the 2001 and 2003 tax cuts, due to expire by the end of 2012, remain in place. We have changed our assumption on this because the majority of Republicans in Congress continue to resist any measure that would raise revenues, a position we believe Congress reinforced by passing the act.

If U.S. Treasury bond investors take heed of S&P's downgrade, they could demand higher interest rates from the government — which would in turn cause interest rates to rise on all Americans. Yet despite the worries stirred up by such a worst-case-scenario "if," President Obama has taken a more reassuring position. In remarks on Monday, he maintained that U.S. treasuries are still the safest investment in the world and that the government is fully capable of paying its debt.

"Markets will rise and fall, but this is the United States of America," the president said. "No matter what some agency may say, we've always been and always will be a AAA country."


Obama agreed with S&P on one thing, though: Political gridlock has indeed kept the government from effectively managing its debt. "We knew from the outset that a prolonged debate over the debt ceiling — a debate where the threat of default was used as a bargaining chip — could do enormous damage to our economy and the world's," he said — although without specifically calling out Republicans.

With that, he launched into his regular stump speech as of late, about solving the debt problem with measures beyond just spending cuts.  


"Last week, we reached an agreement that will make historic cuts to defense and domestic spending. But there's not much further we can cut in either of those categories," he said. "What we need to do now is combine those spending cuts with two additional steps: tax reform that will ask those who can afford it to pay their fair share and modest adjustments to health care programs like Medicare." 

So … are we going to be OK or not? The Root spoke with Wilhelmina A. Leigh, senior research associate on economic security for the Joint Center of Political and Economic Studies about what the credit downgrade means for your finances, S&P's spotty track record on good judgment and whether this will give Congress the urgency it needs to seriously tackle the deficit.


The Root: Should S&P have downgraded the U.S. credit rating?

Wilhelmina A. Leigh: I'm not sure I can answer that question. I have to assume that S&P has a list of criteria that you have to meet for a certain rating, and that they made their assessment based on that. However, I'm also aware that before the rating was downgraded, there had been conversations between the Treasury Department and S&P about it.


S&P made a mistake in how they assessed what our debt would be by the year  2021 — their math as off by $2 trillion. The Treasury Department pointed out that S&P's numbers were in error, and then it appears that S&P said, "Well, we're going to go ahead and [downgrade you] anyway." That could cast some doubt around S&P having looked carefully at whether the U.S. meets AAA criteria. If they decided to just do it based on erroneous data, that could put the downgrade in a different light.

TR: S&P's past mistakes also include AAA ratings provided for Enron, Lehman Brothers and the subprime junk mortgages that triggered the 2008 financial crisis …


WAL: I think, in some ways, they may have done this as a way to try to clear up their own bad image — to make it seem like, "This country screwed up, but we're on top of things."

TR: There have been some foreboding suggestions that the S&P credit downgrade means that our standing in the bond market will plummet, causing creditors to turn away from U.S. Treasury bonds and hike up our interest rates. Is that an accurate forecast?


WAL: I don't know that S&P has that much power. If the other rating services, Moody's and Fitch, followed suit, then I would say that we should be very, very concerned. I think what happens from here depends on what the other rating services do.

In the meantime, President Obama is correct that U.S. Treasury bond is one of the most stable, if not the most stable, investment that can presently be made. Our standing in the bond market is still very good, even though the stock markets have gone a little crazy. But there are so many uncertainties, and that's the bottom line here. If the U.S. were facing its challenges, and there weren't ongoing problems in the rest of the world, like in the European markets, then I don't think people would be as jittery about it.


TR: Do you think that more credit rating agencies will follow suit?

WAL: My sense is that if they were going to, they would have done it by now. Moody's, for example, mentioned earlier that they were monitoring the [debt ceiling negotiations] very closely, and I think enough time has passed for them to have looked at how that situation was handled and have made their assessment. So far they haven't acted.


TR: President Obama suggested that the downgrade will light a fire under lawmakers on the joint "super committee" to get serious about taking a balanced approach that combines budget cuts with raising tax revenues. Do you think this stands to make a difference in our gridlocked political discourse around the deficit?

WAL: When I heard that S&P had downgraded the U.S. credit rating, I thought, Maybe this will jolt Congress into realizing that this is more serious than just saying, "Oh, we can pay off our interest but we don't have to pay off the principal." I mean, something has to wake these folks up. It's like cutting away bone and flesh without adding anything. You just can't solve the problem that way.


TR: What if Democrats and Republicans are unable to bridge their differences on that issue? Is there any other way to get the economy growing, or are we just stuck?

WAL: The only two general ways that I know to do that are to cut spending, and the other is to raise taxes. The form that doing either one of those takes will make all the difference. Hopefully, whatever package they come up with will have in it enough of a stimulating effect, so that the economy can move forward. It's not going to be pleasant for many people, but if they can do it in a way where people can see progress, economic growth and a light at the end of the tunnel, then that amounts to something.