The downgrade of the U.S. credit rating from triple-A to AA-plus by the credit rating agency Standard & Poor's may not sound like a big deal, but it marks the first time since 1941 that the U.S. government hasn't carried the highest rating at any of the major ratings agencies, and it hit global financial markets like a bombshell.
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Coming at a time of serious uncertainty and pessimism about the economy, the downgrade could have major consequences for investors, borrowers and the American economy.
Short-Term Pain for Stock Market
Although a major, long-term collapse in stock market values is unlikely to result from the downgrade, individual investors may panic and cause a short-term stock sell-off, says Sam Wardwell, investment strategist for Pioneer Investments in Boston. On the first day of trading after the downgrade, the Dow Jones Industrial Average fell by more than 634 points.
"In the short term, there might be some retail investors who panic, but professional investors, I think, by and large won't panic because the ratings agencies & aren't really telling us anything we don't already know," Wardwell says.
"The impact on the economy, if you think about it in terms of corporate profits and therefore the appropriate price-earnings ratio for the S&P 500 (index), it's not a very strong linkage at all. But you can never tell what the panicky retail investor who listens to too much TV and talk radio will do," he says.
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Jim Nadler, president of the New York-based Kroll Bond Rating Agency in New York, says the long-term impact of S&P's downgrade on stocks is not as important as more fundamental factors such as corporate earnings, gross domestic product, or GDP, growth and consumer demand.
Even so, the S&P decision could have a long-term impact on stocks if it hampers the so-called repo markets. In the repo market, large financial institutions take out overnight loans from one another to meet their short-term funding needs, customarily putting up U.S. Treasuries as collateral. If those Treasuries are seen as riskier investments going forward, banks will likely have to put up more of them to get the same-size loan, increasing their borrowing costs and reducing profits, Nadler says.
Another possible way the S&P downgrade could depress your portfolio is by inducing a wave of "forced selling," Nadler says. Many stock and bond funds as well as big institutional investors such as insurance companies have guidelines requiring them to hold a certain percentage of assets graded by ratings agencies as triple-A. Because Treasuries are now graded at less than triple-A by one ratings agency, it's possible that these guidelines might force these funds to sell Treasuries to meet their quality requirements. A big sell-off could lower the price of Treasuries, reducing the value of Treasury holdings by other firms and triggering a severe market reaction.
Still, Nadler says that's not likely to happen. He says few of the contracts and standards in the industry require a triple-A rating from S&P itself. As long as the other two major ratings agencies, Moody's and Fitch, don't follow suit with a debt downgrade, forced selling of Treasuries shouldn't happen at such a large scale to have a catastrophic effect on global markets, Nadler says.
Treasuries Still Safe
Despite the downgrade, Treasuries are still functioning as a safe haven for global investors. That's because despite its deficit and political shortcomings, the U.S. is still perceived as less risky than most other industrialized countries, especially those weighed down by more serious debt troubles, such as Spain and Italy.
That special status has kept U.S. Treasury values high and interest rates low throughout the recent series of high-profile political crises culminating in the debt-ceiling debate, Nadler says. He compares it to the old joke about the three friends who encounter an angry bear in the woods.
"You don't have to be the fastest runner in the world, you just have to outrun your two friends," Nadler says.
Impact on Consumer Loan Rates
For consumers, a downgrade in their credit rating usually goes hand-in-hand with higher borrowing costs. With S&P announcing on Aug. 8 that it has also downgraded federal mortgage giants Fannie Mae and Freddie Mac, which guarantee and securitize the vast majority of mortgages in the U.S., you'd think mortgage loan rates would be guaranteed to go up substantially.
Not so fast, says Gerald Epstein, professor of economics and co-director of the Political Economy Research Institute at the University of Massachusetts Amherst.
"It seems like in terms of interest rates, and given the turmoil that's happening elsewhere and the fact that it was just Standard & Poor's and not the other ratings agencies, and that there are not a lot of alternatives to U.S. debt as a safe haven, the short-term interest rate effects might be pretty muted," says Epstein. "But we're entering uncharted territory, so nobody really knows."
Wardwell says in isolation, S&P's move would push loan rates up, but not enough to overcome the downward pressure from the global flight to quality going on right now. As long as the U.S. remains a safer place to invest compared to the rest of the world, rates should remain low, he says.
In the medium term, Epstein says economic fundamentals will have a greater effect on investors' perceptions about how likely U.S. borrowers will be able to pay back their mortgage loans.
Rates on Deposit Accounts
It's hard to know how banks will respond to the downgrade when it comes to rates on deposit accounts.
Wardwell says he believes banks may look to build up larger reserves to ride out the current uncertainty over sovereign debt. In that case, rates on deposit accounts would climb to reflect greater competition for depositors' money.
But Epstein is less optimistic.
"If this is perceived as an increase in risk, then what banks try to do is increase their margins. They might start to charge somewhat more for loans, but they don't want to pay more for deposits," he says. "So I don't think this is any good news for depositors."
Behind the Rating
With all the chaos that has accompanied S&P's move, it might be natural to wonder what is behind the downgrade.
"One (reason) is the obvious, and that is the growing deficit and, in (S&P's) view, the inability of Congress to deal with it," Nadler says.
Nadler says the S&P set up the downgrade by calling for more than $4 trillion in deficit reduction during the debt ceiling debate. When that reduction didn't materialize, S&P was boxed in to respond with a downgrade. "S&P has really put themselves as a player in this game instead of remaining a referee. The question would be: 'Have they lost their objectivity?'" Nadler says.
There may have been an element of political gamesmanship in the downgrade, Epstein says, particularly considering the rating agency didn't reconsider its rating after making a $2 trillion mathematical error in its explanation of the change.
Without that error, Epstein says the U.S. debt outlook doesn't look much different from that of countries whose triple-A ratings have been left intact by S&P. The downgrade may have been, in part, a reaction to criticism by U.S. officials of the agencies for signing off on risky mortgage-backed securities that contributed to the financial crisis.
Long-Term Economic Prospects Troubling
The biggest long-term danger from the downgrade could be a bigger push for government austerity here and abroad, which could slow economic growth dramatically, Epstein says.
"If (the ratings agencies) push each country individually to cut back on spending and cut their deficits, what they're going to do is push the whole world economy down, cutting GDP all over the world," says Epstein. "It's a self-defeating, self-feeding negative process."