Downgrading the USA

Downgrading the USA

Posted by Sam Jones on Sep 22 11:35.

A sovereign’s future debt path can not only be determined by its existing stock of debt, its future budget balances, real interest rates, and exchange rates, it can also be determined by discrete, one-off events that add to the government’s debt burden. Such events can stem from financial difficulty at the state or local government level (which, in aggregate, draw from the same base of taxpayers as the federal government), at the level of public enterprises, or from the financial sector.

In April this year, S&P issued a report which spooked markets, titled: “For the U.S. ‘AAA’ Rating, Government-sponsored enterprises pose greater fiscal risks than Brokers.”

The above par is a particularly germane extract.

At the time of the report, S&P concluded that the Bear Stearns bailout was not a significant enough “contingent liability” to weigh on the US credit rating. The significance of such liabilities, wrote the rating agency, is dependent on their size relative to GDP. At less than 1 per cent of GDP, the broker-dealer bailout costs were “immaterial to our view of the US government’s credit quality.”

The report, however, added:

Not all of the U.S. government’s contingent liabilities are too small to have a significant impact on sovereign credit quality.

S&P’s analysts had Fannie Mae and Freddie Mac in mind. Their conclusion was that consolidation of both posed a risk to government at “3%-8% of GDP”, on which basis:

We believe they [Fannie and Freddie] pose large contingent fiscal risks that recent policy decisions aimed at supporting the U.S. mortgage market have made even larger. If these risks were to translate into increased government debt, they could even hurt the U.S.’s credit standing.

Two weeks ago, of course, the US government did bail out Fannie and Freddie. And then it bailed out AIG for $85bn. And then it provided an unqualified backstop to the $3.8 trillion money market fund universe, and now it’s going to buy up $700bn of toxic mortgage debts.

US GDP is around $13 trillion dollars. The current bailout packages, taken together, are already, conservatively, weighing in at 10 per cent of GDP. By S&P’s own criteria, this is a huge “contingent liability” and according to their April report, should almost certainly “hurt the US’s credit standing”.

There are, though, other factors S&P considers in rating sovereigns:

• Political risk
• Income and economic structure
• Economic growth prospects
• Fiscal flexibility
• General government debt burden
• Offshore liabilities
• Monetary flexibility
• External liquidity
• External debt burden

It’s pretty shocking, but the outlook on any of these counts isn’t really good. “Income and economic structure” is the one category the US does well in, but even then, not very well (the category includes consideration of labour flexibility, income disparity, availability of credit, and degree of protectionism).

Will S&P downgrade the US?

Perhaps the question is better posed: why hasn’t it already?

Inevitably because no matter what the rating criteria say, the US AAA is surely too sacred a cow to be slaughtered. It would be an earth-shattering decision to take, and one that S&P’s sovereign rating committee could not make alone.

Then again, as S&P’s sovereign rating committee chairman said only last week, the US AAA is no god-given gift.

This entry taken from Sam Jones on Monday, September 22nd, 2008 at 11:35 and is filed under Capital markets, People. Tagged with Standard and Poor's, usa.