First, let’s talk about how securities ratings works. The three ratings agencies; Standard and Poor’s, Moody’s, and Fitch, take a look at various securities and based on the contents of those securities rate them assign a rating. Here’s the ratings scale (Moody’s/S&P & Fitch):
- Aaa / AAA – Highest quality, very low risk. Many pensions and other funds are required to invest in a certain percentage of AAA-rated securities, as their appetite for risk is very low
- Aa /AA – High quality, slight risk
- A /A – Strong, some risk
- Baa / BBB – Medium Grade, Basically 50/50 on risk of default. BBB is the lowest grade considered “Investment grade”
- Ba-B / BB-B – Speculative, Higher than 50/50 rate of default
- Caa-Ca-C /CCC-CC-C – Highly speculative. Almost assured of default
- C / D – In Default
The further down the ratings scale you move, the greater the potential return on your investment, but the more risk you take on that you might lose your investment. For example, AAA rated securities have very low returns, but are virtually assured of not defaulting. A, BB or CCC rated security would have a huge return, but there’s a pretty decent chance that you’ll lose your money as well.
Generally speaking, the bonds issued by large industrialized nations are considered to be virtually risk-free, as they can always raise revenue through taxation. Even the largest and most stable corporations don’t approach the level of security that first world countries provide. Corporations cannot raise revenue out of nothing; they have to generate profit. Essentially, if your biggest and most stable corporations are considered “blue-chip” firms, sovereign debt is gold, silver, and platinum chips.
When an institution is in peril of being downgraded the ratings agencies typically warn that institution that they may face a downgrade unless certain steps are taken. Very rarely are these things a surprise. For weeks, S&P, Moody’s, and Fitch all warned the US Government that default was unacceptable for an AAA-rated country, and that major structural changes needed to be made in both our entitlements and spending, as well as revenues. Although we did raise the debt limit, ensuring that we didn’t default, the deal that Congress passed and the President signed failed to make the long term structural changes necessary to bring our debt problem under control.
In the S&P press release, they specifically compare the United States to Canada, France, Germany and the UK. Specifically, they note that by 2015, the net public debt burdens of these nations will begin to decline, whereas ours will not, which lead to their decision to downgrade the United States’ debt rating.
What this will mean for the United States is that interest rates will have to rise slightly to compensate for the perception of increased risk. Projections put the additional interest payments somewhere in the neighborhood of $100 billion, or $322 for every man, woman, and child in America.
What happens next will depend mostly on what Moody’s and Fitch decide to do. If they continue to hold the US at AAA, then there should be very little change. On the other hand, if they decide to downgrade us to AA+ like S&P, we’re boned. Remember all those pension funds and whatnot that are required, by law, to have AAA-rated securities? Yeah, the vast majority of those securities are debt issued by the US Treasury. There exists the potential for these funds, and pretty much everyone that holds US Treasury debt, to make a run on the Treasury. This is, by the way, the worst possible case scenario, but it’s literally the worst possible scenario.
To avoid default, the government would have to raise taxes to usurious levels. If the required legislation couldn’t pass Congress, we’d be looking at a complete financial meltdown that would make the Wall Street crash of 1929 look like a stroll in the park. We’re talking complete financial meltdown of every major economy on the planet, because everyone is heavily invested in US debt since it’s considered to be the safest debt there is.
On a day to day basis, the downgrade will, most likely, not affect anyone unless they choose to invest in the stock market. Things might be a little wacky for a while, but should calm down in the next few days and weeks.
Now, there are two paragraphs from the S&P press release that are essential to read, so we all know exactly who is responsible for this mess (emphasis added).
“The political brinksmanship of recent months highlights what we see as America’s governance and policymaking becoming less stable, less effective, and less predictable than what we previously believed. The statutory debt ceiling and the threat of default have become political bargaining chips in the debate over fiscal policy. Despite this year’s wide-ranging debate, in our view, the differences between political parties have proven to be extraordinarily difficult to bridge, and, as we see it, the resulting agreement fell well short of the comprehensive fiscal consolidation program that some proponents had envisaged until quite recently. Republicans and Democrats have only been able to agree to relatively modest savings on discretionary spending while delegating to the Select Committee decisions on more comprehensive measures. It appears that for now, new revenues have dropped down on the menu of policy options. In addition, the plan envisions only minor policy changes on Medicare and little change in other entitlements, the containment of which we and most other independent observers regard as key to long-term fiscal sustainability.”
“Compared with previous projections, our revised base case scenario now assumes that the 2001 and 2003 tax cuts, due to expire by the end of 2012, remain in place. We have changed our assumption on this because the majority of Republicans in Congress continue to resist any measure that would raise revenues, a position we believe Congress reinforced by passing the act. Key macroeconomic assumptions in the base case scenario include trend real GDP growth of 3% and consumer price inflation near 2% annually over the decade.”
Only one political party is virulently anti-tax and anti-revenue. Only one political party has used the debt ceiling and the threat of default as a hostage in negotiations over fiscal policy. Only one political party has tacked hard toward their base. And only one political party supports extending the Bush era tax cuts into perpetuity. There are going to be people that say that Democrats are just as responsible. They’re wrong. I’m not going to say they’re lying, although many of them are, but they are all wrong.
Feel free to call your Republican senators and congresspeople and thank them for costing you, your spouse, your children, your family, and every other American $322. Republican intransigence over revenue increases is directly responsible for the downgrade. It’s right there, in black and white. Their refusal to allow the Bush era tax cuts to expire in 2010, their refusal to include revenue increases in the debt ceiling deal, and their almost assured refusal to allow those tax cuts to expire in 2012, is what is responsible for this mess.
There is an ancient Chinese curse, “May you live in interesting times.” Ladies and gentlemen, welcome to interesting times.
