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Wednesday, August 17, 2011

Standard & Poor’s Downgrade of U.S. Government Long-Term Debt

Mark Jickling
Specialist in Financial Economics

On August 5, 2011, Standard & Poor’s (S&P) lowered the credit rating of long-term U.S. government debt from AAA (the highest possible rating) to AA+. The downgrade reflects S&P’s judgment that (1) the recent Budget Control Act (P.L. 112-25) falls short of what is needed to stabilize the government’s fiscal situation and (2) the capacity of Congress and the Administration to deal with the debt has become less stable, effective, and predictable.

A ratings downgrade is meant to signal the market that an issuer of bonds or other debt securities is less likely to repay interest or principal. In municipal and corporate bond markets, in which investors may choose among many similar debt issues, a downgrade usually leads to higher borrowing costs, as investors demand higher interest rates to compensate for greater perceived risk. U.S. Treasury securities, however, play a unique role in the global financial system, meaning that past experience with downgrades of private or government debt may not apply.

U.S. government bonds have long been considered the “risk-free” baseline against which other investments are measured; they are a global “safe haven” during financial crises; they serve as collateral in a wide range of financial transactions; they are held by many financial institutions around the world, including central banks. Even if holders of Treasury debt wished to switch to other debt instruments, no immediate substitute is available in many cases.

The long-term impact is difficult to gauge. There may be no visible effects, at least in the short run. Many in the market could question whether S&P has special insight into U.S. political dynamics. Hundreds of billions in Treasury securities change hands daily, and each trade represents a judgment about default risk (among many other things). During the recent debt ceiling negotiations, Treasury yields did not rise significantly, nor was there any flight from Treasuries during the first trading sessions after the downgrade.

On the other hand, the downgrade may be a step in a gradual process that erodes the United States’ central position in the global financial system and the dollar’s role as reserve currency. These developments could make the process of dealing with the U.S. budget and trade deficits more difficult.

The downgrade has implications for other debt markets, but is not likely to produce sudden, disruptive changes. Mutual and money market funds that hold Treasuries may suffer slight losses in value, but it does not appear that the loss of a AAA rating in itself will mandate large amounts of forced selling by these institutions or other investors such as pension funds. S&P also downgraded bonds issued by entities linked to the Treasury, including the Federal Home Loan banks, the Farm Credit System, and Fannie Mae and Freddie Mac. Borrowing costs at those institutions are subject to the same uncertainty that applies to the U.S. Treasury.

Bank regulators issued a statement on August 5, 2011, that depository institutions will not be required to hold more capital to offset greater perceived riskiness of Treasury securities.

The effect on consumer and business interest rates depends on what happens to Treasury interest rates. Many private borrowers pay rates that are implicitly or explicitly linked to Treasury rates; if Treasury securities pay higher interest, mortgage, credit card, automobile, and business loans are likely to become more expensive as well. But the downgrade alone need have no effect on those rates.

Date of Report: August 9, 2011
Number of Pages: 10
Order Number: R41955
Price: $29.95

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