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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+.

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.