By Peter Schroeder - 06/25/11 10:40 AM EDT
Investors with holdings in U.S. debt could lose $100 billion if the country’s credit rating is downgraded, a leading Wall Street forecaster says.
Standard & Poor’s predicts losses of that magnitude if the U.S. government’s perfect AAA credit rating is taken away over concerns about the federal deficit.
Michael Thompson, the managing director of S&P’s valuation and risk strategies — a wholly separate unit from its ratings shop — said the report tackles what was long thought to be unthinkable.
“What we’re really trying to do is give people in the marketplace a prism … to what the effect [is] of something they’ve never really bent their minds to,” he said. “People never really went down this analysis because they just thought it was an impossibility.
“That’s starting to erode a little bit,” he added.
A downgrade is not imminent from any credit rating agency, but the 'Big Three' ratings firms have not shied away from expressing their concerns about the nation’s financial situation.
In April, Standard & Poor’s lowered its outlook on U.S. debt from “stable” to “negative,” citing growing pessimism about lawmakers’ ability to rein in the deficit.
Moody’s Investors Services chided lawmakers in June for political gamesmanship, warning that its rating on U.S. debt could be put on negative watch if “credible agreement” to tackle the deficit is not reached in the coming weeks.
Fitch Ratings followed suit a few days later, announcing the U.S. rating would be put on negative watch if a deal to increase the debt limit is not reached by August.
To figure out what might happen if any of those threats were to become a reality, Standard & Poor’s looked to the cost of insuring a nation’s debt against default through the use of a credit default swap (CDS). A CDS effectively is an insurance policy that protects an investor if a borrower defaults; the safer the borrower is perceived to be, the cheaper it is to buy insurance.
By effectively comparing the costs of a CDS for American debt with the cost for insuring against the debt of other nations of varying creditworthiness, Standard & Poor’s painted a rough picture of what a lower-rated America would mean for investors — and it’s not pretty.
Standard & Poor’s said in its report that investors could suffer losses that “could easily range from $50 to $100 billion” as prices for existing Treasury bonds could fall by up to 6 percent.
And they point out that it’s not just investors in American debt that would suffer from a downgrade. A consequence would be increased borrowing costs for the government, as it would have to boost interest rates to attract investors for a now-riskier security.
That change might seem paltry, but when dealing with a deficit of over $1 trillion, those small boosts can add up. By the firm’s math, that shift would mean an additional $2.32 to $3.75 billion a year just in additional interest.
Thompson pointed out that there is a snowball effect as well. If the nation’s credit rating is downgraded due to the inability to deal with the deficit, the added interest costs will make it that much harder to rein it in going forward.
“You think the deficit’s bad now? Wait until you actually have to pay real interest on your debt,” he said.
However, the S&P report is not all bad news for the U.S. The firm points out in its report that if Washington can put together a plan to tackle the deficit that convinces Standard & Poor’s to return to its stable outlook, the interest rate on Treasury bonds could fall by 11.4 basis points.