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A U.S. Debt -- and Prestige -- Downgrade?

Author: Christopher Alessi
Updated: July 29, 2011

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Even if lawmakers in Washington are able to reach agreement to avoid default (Politico) ahead of the August 2 deadline,  it may not be enough to stop leading credit rating agencies from downgrading the United States from its AAA rating. The three leading agencies – Standard and Poor's, Moody's, and Fitch – have indicated that if the United States does not implement a "credible" (Bloomberg) and comprehensive deficit-reduction package that would see savings of around $4 trillion over the next ten years, a downgrade  of U.S. Treasury debt could be imminent. Economists, analysts, and investors have warned that such a move would raise U.S. borrowing costs and slow overall growth, with global economic repercussions.

"The fundamental conditions are there for a downgrade," says Uri Dadush, a senior associate and director at the Carnegie Endowment International Economics Program. "The United States shares an AAA rating with countries like Germany, France, and the UK," Dadush explains, "all of which have significantly lower debt levels – and a better debt trajectory – than the U.S."

S&P President Deven Sharma (LAT) told a congressional hearing July 27 that agency analysts did not think the United States would default, but faced the prospect of a downgrade because of Washington's inability to agree on spending cuts and revenue increases.

A downgrade's impact on U.S. Treasury yields could increase the government's interest payments by as much as $100 billion per year (Bloomberg), said Terry Belton,  global head of fixed income at JPMorgan Chase. Belton added that the size of the increase depends on how much longer the Washington political stalemate drags on over a deficit agreement.  Pacific Investment Management Co. CEO Mohamed El-Erian said Congress will likely raise the debt ceiling before the United States defaults, but the country still faces a significant risk (NYT) that it will be downgraded. "A downgrade would mean a weaker dollar, somewhat higher interest rates anda further blow to the already fragile national economic confidence," said El-Erian. Global investors are beginning to lose faith in the dollar, which could weaken its position in global trade as the world's reserve currency, writes Reuters' Steven Johnson.

Other analysts remained less sure on the market impact of a downgrade. "I see a downgrade as being inevitable," Peter Cohan, a financial analyst and head of venture capital firm Peter S. Cohan and Associates, told the Daily Beast. But, he said, what remains unknown is "whether markets see that as being significant." CBS' Carla Fried argued that its impossible to know "what impact a credit downgrade would have on our financial lives." She outlined six possible ways that a downgrade could affect the U.S. economy: borrowing costs could rise by $100 billion; variable rates tied to government benchmarks could rise; mortage rates could rise; mortage-backed bonds could also face a downgrade; money market mutual funds could come under pressure; and the price of foreign goods could rise.

A downgrade of U.S. sovereign debt would also put government-backed agencies, banks, and insurers at risk (CNN) of being downgraded. Even non-financial U.S. corporate borrowers that maintain an AAA rating would be in jeopardy. Though, S&P said that if Congress raises the debt-ceiling but still gets downgraded slightly (WSJ) to a rating of, say, AA, they don't expect "significant market disruptions."

Deutsche Bank's Alan Ruskin told the Economist that a one notch downgrade is "unlikely to be a global contagion event, and global risk appetite should not take a sustained hit, beyond the immediate U.S. equity market reaction in the days immediately surrounding the event."

Selected Analysis:

A downgrade of U.S. Treasury debt may not be "catastrophic," but it is a sign of U.S. fiscal mismanagement and an indicator of things to come, says a Wall Street Journal editorial.

The prospect of a U.S. debt downgrade could deal a psychic blow to the country and presidency, at a time when concern is already mounting about China's rise, write Politico's Carrie Budoff Brown and Ben White.

While markets may become more volatile in the immediate aftermath of a one notch downgrade of U.S. debt, investors and borrowers should be able to ride it out, says this analysis by Tara Siegel Bernard in the New York Times.

Financial analysts Janet Tavakoli argues in Business Insider that "the current 'AAA' rating of the United States is not on merit, but it is a convenient fiction for the global financial markets, because no one yet has an alternative."

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