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S&P was right in downgrading U.S. debt

There is no getting away from it. Standard & Poor’s created a huge controversy when it decided to downgrade the credit rating of the U.S. government from AAA to AA+. Newspapers continue to have headlines such as “S&P Is Facing a Bipartisan Backlash in Washington.” Cable television shows bring on guests to talk about the downgrade. The consensus of what I read and watch is that S&P made a mistake.

But let’s take a look at why and how ratings are made.

Investors buy bonds to get income. Bond investors large and small want to receive the periodic interest payments and their original principal amount back when it comes due. Investors, prior to buying a bond, want to understand the risk to them that the issuer will not be able to make these payments on time.

So credit rating agencies were created as businesses to help investors understand that risk. They analyze bond issues and provide credit ratings, which are a measure of risk. Bonds that are rated AAA have the least risk. Bonds with a C rating carry considerable risk. Bond buyers use the credit ratings in making the decision on whether or not to buy a bond.

Looking forward, not back
Credit ratings are not determined by doing a historic ratio analysis and the issuers with the best ratios are the highest rated. Ratings are forward looking to see if the bond issuer will be able to make the future interest and principal payments on time.

Because of the budget deficits, the amount of revenue coming into the U.S. Treasury each year is less than the amount being spent to pay for the many things that Congress appropriates money for. The result is the need to sell Treasury obligations (bonds, notes and bills) to provide money so each day there is sufficient cash in the Treasury to pay for everything. Congress controls the debt by passing legislation that sets the maximum amount of Treasury debt that can be outstanding. This is known as the debt ceiling.  

U.S. Treasury obligations are backed by the full faith and credit of the U.S. government. This is an unconditional guarantee of the government to pay the principal and the interest on its bonds. Treasury bonds have been considered the safest investment. Hence, they have been rated AAA.

A condition on the guarantee
However, this unconditional guarantee now has a condition. The Treasury secretary projected that the maximum debt ceiling would be reached on Aug. 2. If the debt ceiling was not raised the Treasury cash balance would not be sufficient to pay all the bills. The payment of the interest and principal on outstanding U.S. Treasury obligations could be included in the payments not made. The result would be the United States defaulting on its debt. That has never happened. So the condition on the unconditional guarantee is that on a future day there may not be sufficient cash in the Treasury to make the interest and principal payments.

The proposed legislation to raise the debt ceiling was tied to deficit reductions. Partisan politics dominated the legislative debate. During the weekend of July 30 and July 31 the Republican-controlled House of Representative worked on debt-ceiling legislation that everyone knew would never pass in the Senate, and the Democratic controlled Senate worked on debt ceiling legislation that everyone knew would not pass in the House. The clock was ticking toward a default as they did this. Finally a compromise agreement was reach by President Barack Obama, the House and the Senate, the legislation was passed, and the president signed the bill into law. This legislation became law only hours before a default could have occurred.

A chance for default before compromise next time?
Is it good financial management to come within hours of default?  No it is not. Based upon the partisan politics that dominated the discussion on raising the debt ceiling, is there a chance that the next time it needs to be raised the compromise agreement will be reached after the Treasury has run out of cash and the United States has defaulted on its debt? Yes, there is that chance.

S&P was right in downgrading the United States debt. Credit ratings are a measure of risk. Partisan politics has placed a condition on the unconditional guarantee to make interest and principal payments on time. This is a risk investors should not expect of a AAA issuer.

Peter Sausen retired as an Assistant Commissioner of Finance for the state of Minnesota in 2007. He was responsible for rating agency relationships for 25 years.

Comments (8)

  1. Submitted by Richard Schulze on 08/25/2011 - 07:24 am.

    The reputations of the ratings agencies are still stained by their gross overstating of the quality of mortgage-backed bonds before the credit crisis.

    A credit rating is far less relevant to Treasury bonds than it is to, say, a corporate bond. Above all, S&P’s verdict is based on the uselessness of America’s politicians: both their inability to deal with the budget and their vividly displayed political brinkmanship. S&P argues that America’s policymaking has become less predictable and its finances less manageable.

  2. Submitted by houlios1 houlios1 on 08/25/2011 - 09:26 am.

    Let us not forget that S&P specifically cited the GOP’s opposition to new revenue and willingness to cause a default as reasons for the downgrade.

  3. Submitted by myles spicer on 08/25/2011 - 09:35 am.

    As I wrote in a recent Strib op-ed, the whole idea if a “debt ceiling” is archaic…silly…not used by any other industrialized nations…has great opportunity for mischief…allows extreme groups to hold the U.S. hostage to other demands (totally unrelated to fiscal policy)…and has clearly harmed America’s credit for no good reason at all.

    The S&P decision was based strictly on this frivolous partisan dispute — NOT at all the
    credit-worthiness of our nation. The problem is less the credi raters but more the need to eliminate the silliness of a “debt ceiling”

  4. Submitted by Dan Hintz on 08/25/2011 - 11:50 am.

    What a worthless article.

    I don’t think anyone would disagree that it was not good that the parties resolved the debt ceiling issue right before a default occurred. But any real anaysis of how credit ratings like Standand & Poor’s work would have looked at their miserable record in recent years, and the AAA ratings that were given to a number of entities in 2008 (i.e. AIG) just before they collapsed. The Justice Department is actually investigating S&P for their role in the housing market collapse – being esssentially paid off to give AAA ratings to worthless securities.

    I also think it is worth noting that there was a rush on treasury bonds after the downgrade.

  5. Submitted by Scott Andrew on 08/25/2011 - 01:08 pm.

    The debt ceiling deal purports to reduce budget deficits $2 trillion over 10 years, with only $21 billion out of a total of $3.7 trillion in expenditures, less than 1% of the cuts, coming in the 2012 budget (http://eng.am/nERaq2). The Congressional Budget Office projects that by 2021 federal debt will be over $20 trillion.

    If you were behind on your credit card bills and only paid the 10% of the total bill each time, you would never be out of debt. If you gained 10lbs every year and wanted to slim down for the beach, gaining only 5lbs each year would not be a solution. So how can it be that, while our national debt increased 300% in the past decade, our plan forward is to cut it only 10% this next decade?

  6. Submitted by Richard Schulze on 08/25/2011 - 04:59 pm.

    Scott makes the perfect case for not renewing the Bush era tax cuts.

  7. Submitted by Daniel Smith on 08/27/2011 - 04:24 am.

    Has anyone noticed that the few nations with AAA ratings are all, save perhaps Singapore, significantly to the Left of the US? In fact, most are referred to as “socialist democracies” that collect much more in income tax and spend a much greater share of GDP on caring for the basic needs of all their citizens through what’s derided by conservatives as a “nanny state”. Again, almost all, save Singapore, also rank very high on the Happiness scale (google it). Hmmm, what are we to make of that?

  8. Submitted by Susan Taplin on 12/09/2011 - 09:03 am.

    S&P decided to lower the AAA rating, held by the United States for 70 years, to AA+ after a bipartisan debt deal signed into law failed to assuage concerns about the nation’s growing spending. As it seems compromising with the President and Democrats was a disaster. Thanks Dems for your inability to accept spending cuts and then screaming about being held hostage. As it turns out, the deal should have been much tougher and the Republicans should have never agreed to this miserable deal.

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