Alexander Hamilton established the “full faith and credit” of the U.S. in 1790 when he pushed to have the newly created U.S. Treasury to assume and repay debts that states incurred during the fight to win our independence from Britain. Subsequent administrations have made sure to preserve the longstanding guarantee on the public debt, with only one small black mark on Uncle Sam’s impeccable credit, a 1970 debt-ceiling argument that delayed a few payments.
Standard & Poor’s, a credit ratings firm, recently shook the global financial system when they removed for the first time the triple-A rating the U.S. has held for 70 years. S&P downgraded long-term U.S. debt to AA+, a score that sounds good, but ranks below more than a dozen countries, placing the U.S. on par with Belgium and New Zealand. S&P left the triple-A sovereign credit rating of France, U.K., and Germany unchanged despite ongoing problems in their domestic banks and mounting sovereign debt issues that could harm the global financial system. S&P’s decision sparked a firestorm of negative reactions from Obama Administration officials and a flurry of questions from investors and analysts both curious to know what motivated the ratings firm to adopt a “negative outlook”.
S&P officials stated in a press release that the recent “debt deal” in Washington that ended the impasse on whether to raise the country’s statutory debt-limit fell short of the ratings firm’s expectation of what is needed to “stabilize the government’s medium-term debt dynamics.” In other words, S&P expected Congress to develop a fiscal austerity program that would cut more than the agreed upon $2.4 trillion over 10 years, officials were hoping for a minimum of $4 trillion in cuts according to the release. More striking is the ratings firm disclosure that the “political instability” in Washington was a significant driver in their decision-making. Apparently, the U.S. is not only suffering from a “fiscal deficit”, but we also are being severely handicapped by a “leadership deficit”.
Although rival ratings firms Moody’s Investors Services and Fitch Ratings have maintained their respective top-credit ratings for U.S. debt, the downgrade could have a psychological effect and other unintended consequences. Investors’ faith in the American political system is at an all-time low and that deterioration could accelerate as a result of the debt downgrade. States, municipalities, companies, and consumers could all see their borrowing costs increase after credit markets adjust for the paradigm shift on U.S. public debt.
Various types of debt, including mortgages, car loans, and student loans are pegged to the price that Uncle Sam pays to borrow money. U.S. Treasuries are largely considered a safe-haven, so interest rates have been historically low, allowing the U.S. government to finance large budget deficits and a burgeoning public debt. However, investors could begin to demand more return on their investment, if they perceive the U.S. to be a riskier bet – possibly triggering a .50 bps increase in current yields.
Other concerns are centered on our international neighbors and their appetite for U.S. debt. In 1945, foreign countries owned just 1% of U.S. Treasuries; today they own a record high of 46%. In particular China, the world’s largest foreign holder of U.S. Treasuries, currently the Chinese hold 9.5% of the country’s total outstanding debt.
Many predict that China might become more attracted to other countries that have maintained their stellar triple-A credit ratings – Canada and Australia. Largely unlikely considering the size of their public debt markets when compared to the existing $9.8 trillion market for U.S. sovereign debt. The ongoing economic challenges in Europe and other parts of the world should keep U.S. Treasury debt attractive for the foreseeable future.
More importantly, the Federal Reserve, FDIC, and other federal banking regulators have signaled the downgrade would not affect risk-based capital requirements for U.S. banks – the liquidity cushion banks must reserve to protect against potential credit losses. Banks hold an estimated $4 trillion worth of U.S. Treasuries that are pledged as collateral against outstanding loans. S&P left the U.S. short-term credit rating unchanged, so the downgrade is less likely to have a substantive impact to money market funds that hold some $1.3 trillion in U.S. Treasury bills. Any impact to these critical components could have triggered a broad market selloff to raise cash to meet margin calls – recreating the 2008 Lehman Brothers crisis.
Undoubtedly, the real story behind the downgrade to U.S. debt is the view by S&P officials that the “effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges”, many are criticizing the S&P for highlighting political challenges while choosing not to focus solely on Uncle Sam’s unquestionable ability to repay the escalating public debt. However, the ratings firm decision to highlight the “leadership deficit” in Washington is appropriate, and I hope that elected officials pay close to attention to their assessment.
Maintaining the trust of lenders, investors, and taxpayers require our elected representatives to make difficult choices, to place “service above self”, and lead on those critical issues mostly affecting the nation. The American political system is greatly divided and in dire need of leadership to break the political brinkmanship that is restraining economic growth, preventing stability, and harming America’s standing in the world. “Can’t we all just get along?”
