2011

Futures First GHF Group Abhishek Joglekar

[US DOWNGRADE]
So why was this event so important? What events led to it? What are the implications? Well take a birds-eye-view of these pertinent questions.

US Downgrade US Downgrade

We have lowered our long-term sovereign credit rating on the United States of America to AA+ from AAA This line from the 5th of August, 2011 press-release by Standard & Poors marked a historic moment in Financial World as something very significant happened. Something which was unthinkable just a few months back: United States of America, the worlds safest debt lost its sterling triple-A rating first time in post-WWII era!

Who is Standard & Poors?

Standard & Poor's (S&P) is a United States-based financial services company. It is a division of The McGraw-Hill Companies that publishes financial research and analysis on stocks and bonds. The company is one of the Big Three credit-rating agencies, which also include Moody's Investor Service and Fitch Ratings. As a credit-rating agency (CRA), the company issues credit ratings for the debt of public and private corporations.

What is the meaning of Ratings? And how does a downgrade may impact?
The following table summarises kind of debt and rating given by the Big Three CRAs:

US Downgrade

Thus, AAA means that the debt is of prime (best) quality and is treated like almost a risk-free investment. Thus, not surprisingly, many investors only want bonds with an AAA rating. So, obviously, if a debt is downgraded, there is a good chance that it sees investors fleeing from it to a better grade debt. This is called Flight to Quality.

What events led to the downgrade of USA?

The Debt Ceiling: US government was having troubles regarding its so-called debt ceiling. As the name suggests, the debt-ceiling marks the upper limit of how much the government could borrow; thereby putting a check on government spending. This was set at $14.3tn (which is around the current US GDP) and can only be increased if a bill to the effect is passed by the government. The Debt-Ceiling was hit in May-11 and the government needed extraordinary measures to keep themselves funded till first week of Aug-11, post which they would be exhausted of such measures. The Democrat-Republican debate: However, it wasnt easy to simply increase the debt-limit (or ceiling) as it would have indicated reckless spending behaviour of the government and thereby putting risks to its AAA rating. Thus, efforts to reduce budget deficits in the ensuing 10years began. Beginning Feb-2011, the Republicans and Democrats started discussing the ways to reduce the deficits. Soon it became evident that they were at loggerheads about increases in taxes as a means. Democrats wanted it and Republicans vehemently opposed it. What made the situation unique was that a bill needs to be passed by both houses (the Senate and the House of Representatives) to become a law and Senate was Democrats-controlled whilst the House was Republican controlled. The Downgrade Warning: The drop in the rating by one notch to AA-plus was telegraphed as a possibility back in April-2011. The three main credit agencies, which also include Moody's Investor Service and Fitch, had warned during the budget fight that if Congress did not cut spending far enough, the country faced a downgrade. Moody's said it was keeping its AAA rating on the nation's debt, but that it might still lower it. S&P had issued a negative outlook (from stable) on US debt in a statement on 18-Apr-11 to the effect: "The negative outlook on our rating on the U.S. sovereign signals that we believe there is at least a 1in-3 likelihood that we could lower our long-term rating on the U.S. within two years The outlook reflects our view of the increased risk that the political negotiations over when and how to address both the medium- and long-term fiscal challenges will persist until at least after national elections in 2012." The Law: After about 7 months of haggling and intermittent stand-offs, The Democrats and Republicans hurried onto an agreement of $2.1-2.4bn worth of Budget Deficit cuts in the next 10 years. This was much lesser than the $4tn that S&P indicated will be required for US government to maintain its coveted triple-A ratings. In addition, the agreement was to be carried out in 3 steps: A $900bn worth of first tranche cuts was agreed upon by both parties A further $1.5tn was to be agreed upon by a joint-committee by Dec-11 (bring total reduction in deficit to 0.9+1.5= $2.4tn)

US Downgrade

If the joint-committee fails to agree upon $1.5tn, then an the proposal is to initiate automatic spending cuts of $1.2T accompanied by an equivalent rise in the ceiling (total $2.1tn) The Downgrade: It was a much awaited decision by the S&P as there was a dilemma associated with it. If it did not downgrade, then it would mean going back on its words regarding a minimum $4tn cuts. If it did, then it would have to bear political pressures and world-wide criticism for downgrading despite no real fears of a US default (not even a technical one). On 5-Aug-11, it went ahead with the downgrade decision, justifying it by saying T[t]he downgrade reflects our opinion that the fiscal consolidation plan that Congress and the Administration recently agreed to falls short of what, in our view, would be necessary to stabilize the governments medium-term debt dynamics. As expected S&P met with fierce criticism, especially when Treasury officials discovered that S&P officials had miscalculated future deficit projections by close to $2 trillion! Moodys and Fitch maintained the coveted AAA-rating of USA though.

Implications
So, far the downgrade of USA sovereign debt has had a more adverse impact on S&P itself than the US debt. S&Ps Deven Sharma will be replaced as president of the ratings agency by Douglas Peterson, chief operating officer of Citibank effective 12-Sep-11. Whilst S&P battles political pressures and criticism, US debt remains in high demand. Infact, the 10yr yields (a standard measure of return on investment) of US Treasury has dropped about 50bps since the downgrade to around 2%! This effectively means the investors are willing to take 0.5% lesser yield on the 10yr debt today than on the day of downgrade!! One reason for the above is lack of alternatives to the huge US debt. Whilst other AAA-rated sovereign debts are just a fraction of US outstanding debt, other alternatives like Gold are even tinier markets. Another reason is that, investors will not shun a debt unless there are real default fears or the debt is downgraded by at least two CRAs! However, what if in future more downgrades happen, especially from either Moodys or Fitch? This may happen if these CRAs start using the same glasses that S&P did and US government continue to be reluctant in implementing the deficit-reducing mechanisms. It may mean total chaos in financial markets with huge volatility in Treasury prices! Or It may mean that the world assumes AA+ is the new AAA!!