The U.S. Debt Ceiling Standoff Could Reverberate Around The Globe--With Or Without A Deal
|Publication date: 22-Jul-2011 10:08:18 EDT|
(Editor's Note: In the original version of this article, we mistated the principal and interest amounts due in August. A corrected version follows.)
As the Obama Administration and congressional Republicans continue to struggle over raising the government's debt ceiling, Standard & Poor's Ratings Services believes that the reverberations of the showdown may be deep and wide--particularly if Washington does not come to a timely agreement on the debt ceiling.
Our analysts have considered three hypothetical scenarios that could emerge, and we plan to publish articles today detailing our views on the potential effects of each on the financial services industry, corporate borrowers, structured finance, public finance borrowers, as well as economies and markets around the world. The scenarios are as follows:
- Scenario 1--The White House and Congress agree to raise the debt ceiling and collaborate on a long-term framework for fiscal consolidation;
- Scenario 2--The White House and Congress agree to raise the debt ceiling to avoid potential default but are not able to formulate what we consider to be a realistic and credible fiscal consolidation plan;
- Scenario 3--The White House and Congress cannot agree to raise the debt ceiling by their Aug. 2 deadline, and the Treasury begins to sharply reduce spending to preserve cash for debt service and to try to keep within the debt ceiling. Such measures could conclude, if the standoff persisted for just a short while, with the Treasury missing an interest payment or failing to pay off maturing debt, i.e. a default.
On July 14, Standard & Poor's placed its 'AAA' long-term and 'A-1+' short-term sovereign credit ratings on the United States of America on CreditWatch with negative implications, reflecting our view of two issues: the failure to date to raise the debt ceiling so as to ensure that the federal government will be able to make scheduled payments on its debt, and our growing concerns about the likelihood that Washington will agree upon a credible, medium-term fiscal consolidation plan in the foreseeable future. (See "United States Of America 'AAA/A-1+' Ratings Placed On CreditWatch Negative On Rising Risk Of Policy Stalemate," published July 14, 2011.)
While there has been considerable political posturing over the debt ceiling and related issues, credible indication that the government will tackle the problem is important to our evaluation of the U.S.'s creditworthiness. We have previously stated our belief that there is a material risk that efforts to reduce future budget deficits will fall short of the targets set by Congressional leaders and the Administration. In this light, we see at least a one-in-two likelihood that we could lower the long-term rating by one or more notches on the U.S. within the next three months and potentially as soon as early August--into the 'AA' category--if we conclude that Washington hasn't reached what we consider to be a credible agreement to address future budget deficits.
It's unclear whether reaching the debt ceiling would cause the U.S. to immediately default on its debts--the answer depends on the Treasury's willingness and ability to prioritize debt service while implementing steep cuts elsewhere. While possible and riskier as the days pass, we still believe a default is unlikely. We think it more probable that an 11th-hour deal will be reached. As Winston Churchill once remarked, "The Americans can always be counted on to do the right thing?after they've exhausted all other possibilities."
In the interim, further delay in reaching agreement on the debt ceiling will likely continue to cause volatility in global financial markets and may begin to put upward pressure on Treasury yields, which as yet remain historically low. With governments and investors overseas holding large amounts of the almost $10 trillion of outstanding U.S. government debt, foreign selling is a real risk, and an abrupt increase in long-term borrowing costs would curb U.S. GDP growth--a burden that economies around the globe would almost certainly soon share.
In the hypothetical scenarios, we discuss two broad types of implications: those issuers and issues directly affected or linked to the U.S. rating and those indirectly affected. Ultimately, the range and severity of potential rating actions will depend, in our view, on multiple factors--many of them still unknown. Among these are action on the debt ceiling, the nature and severity of cuts to the federal budget, and the subsequent impact on the economy broadly. The most immediate issue is resolution of the debt ceiling. Inaction on this would, we expect, have a wide range of economic, budget, liquidity, and capital market implications across the globe.
Hypothetical Scenario 1--Agreement To Raise The Debt Ceiling And Reduce Debt
If the opposing camps agree to raise the debt ceiling before the deadline and come to terms on a long-term debt-reduction plan, Standard & Poor's would likely affirm the U.S. ratings and remove them from CreditWatch. It is possible, however, that the rating outlook could remain negative while we evaluate the likelihood that an agreed plan will be implemented. Ratings of sub-sovereign credits currently on CreditWatch, including structured financings, would be similarly removed from CreditWatch and affirmed, and their rating outlooks would mirror that of the sovereign.
Yet even under this relatively positive scenario, the resulting fiscal contraction may weigh for many years on an economy already expected to show below-trend GDP growth given the still lingering effects of the credit boom and subsequent bust. Consequently, we believe the economic recovery remains fragile and vulnerable to external shocks. Moreover, even if Washington does avoid a default, investor confidence in the dollar, Treasury securities, and U.S. institutions may suffer lingering effects.
We cannot know what specifically would be cut from the federal budget, but any significant slowing of government spending would have generally negative implications for the economy broadly, in our view, especially for the corporate and government entities that most depend on federal spending.
For example, some public finance issuers may suffer in the long-term because any deal would almost inevitably reduce federal outlays that currently support ongoing assistance such as Medicaid as well as grants that support capital projects and research. Lower ratings could result in some segments of the public sector over time, as federal outlays shrink and the economy struggles to gain momentum.
At the same time, in such a scenario, we believe there would likely be little impact for most financial services entities as this scenario is very close to our existing base-case economic scenario and is, therefore, already reflected in our ratings and outlooks.
Any effects on corporate borrowers would be, in our view, indirect and with some time lag, and would depend on the fiscal consolidation's impact on the path of economic recovery.
Hypothetical Scenario 2--Agreement To Raise The Debt Ceiling But No Credible Agreement To Reduce Debt
From a creditworthiness perspective, we believe that failure to formulate a fiscal consolidation plan, even if the president and Congress were to agree to raise the debt ceiling in time to avert a potential default, would be materially less optimal than hypothetical scenario 1. Such a partial solution would essentially put before American voters in the 2012 presidential and congressional election the spending vs. revenue debate. Meanwhile, debt would continue to mount and the results of the election might not, in any event, resolve the issue.
Under this scenario, we might lower the U.S. sovereign rating to 'AA+/A-1+' with a negative outlook within three months and potentially as soon as early August. We expect that the U.S. transfer and convertibility assessment would likely remain 'AAA'. We assume that under this scenario we would see a moderate rise in long-term interest rates (25-50 basis points), despite an accommodative Fed, due to an ebbing of market confidence, as well as some slowing of economic growth (25-50 basis points on GDP growth) amid an increase in consumer and business caution.
Agreement on raising the debt ceiling without making any tough budget decisions would not be shocking, in our view, given the number of times Congress has done so in the past. And while such a move might modestly raise borrowing costs for the federal government, we view it as relatively benign for public finance issuers. Maintaining the status quo on federal outlays--for the year, anyway--would help alleviate some fiscal stress in the public finance sector, and reduce the prospect of widespread downgrades until and unless a larger solution was reached that cut federal outlays significantly.
While banks and broker-dealers wouldn't likely suffer any immediate ratings downgrades, we would downgrade the debt of Fannie Mae, Freddie Mac, the 'AAA' rated Federal Home Loan Banks, and the 'AAA' rated Federal Farm Credit System Banks to correspond with the U.S. sovereign rating. We would also lower the ratings on 'AAA' rated U.S. insurance groups, as per our criteria that correlates insurers' and sovereigns' ratings.
A scenario that leads to a downgrade of the U.S. government to the 'AA+' level wouldn't affect the ratings of the four U.S.-based corporate borrowers rated 'AAA'. However, we would lower the ratings on three government-related entities--the Army & Air Force Exchange Service, the Marine Corps Community Services, and the Navy Exchange Service Command--in keeping with our criteria.
For structured financing transactions, we would assess the degree of each deal's exposure to U.S. government obligations or guarantees as part of our analysis of whether to affirm or lower the ratings. We think that any potential modest rise in interest rates would not generally affect the ratings of structured finance transactions. We expect that our ratings on non-affected structured finance transactions generally would not be affected by a change in the sovereign rating. Our approach to rating new structured finance transactions, denominated in U.S. dollars, up to 'AAA', would also not generally be affected. However, we might see adjustments in the way proposed new structures address potential changes in interest rate and foreign exchange scenarios. We also believe that new issuance activity may slow moderately under this hypothetical scenario due to market reaction.
Hypothetical Scenario 3--No Agreement To Raise The Debt Ceiling, Increasing The Specter Of Default
Clearly, a failure by Washington to raise the debt ceiling and agree on deficit-reduction measures would lead to significant turmoil--and could prove severe if such a situation lingered long enough to push the government into default. Senate Democrats recently quoted Treasury Secretary Timothy Geithner as saying such a development would be "lights out" for the U.S. economy. And while we think this possibility is the least likely, we find it difficult to disagree that it would wrack global financial markets and likely shove the U.S. economy back into recession.
To start, we envisage that in this hypothetical scenario the Treasury would begin sharply reducing spending to preserve cash to make interest payments and try to stay within the debt ceiling. We might also see the Federal Reserve launch another round of quantitative easing in an effort to be as accommodative as it can. We think it possible that the Treasury could successfully roll over the $87 billion in maturities due on Aug. 4 and Aug. 11, and could make the Aug. 3 Social Security payments, while sharply cutting discretionary spending and delaying payments to state governments, vendors and contractors, and federal employees.
Under this scenario, we expect that interest rates could rise--say, 50 bps on short-term rates and double that on the long end--though this may depend on whether Treasuries would lose their status as the safe haven that investors have historically perceived them to be, or whether physical assets such as gold would benefit from such a flight to quality. Either way, we expect that corporate borrowers would likely see spreads widen correspondingly, and equity markets and the dollar would likely suffer.
Under this hypothetical scenario, we envisage that financial market conditions would worsen considerably in a matter of days. Failure to pay off maturing debt or missing interest payments (approximately $32 billion of interest is payable on Aug. 15) would constitute a selective default pursuant to our criteria, and Standard & Poor's expects it would lower the sovereign rating to 'SD'. Even if the Fed and other central banks managed to keep the financial system functioning, we expect that markets around the world would be severely damaged. In such a hypothetical scenario, we expect that equity markets would generally plunge, borrowing costs and interbank lending rates would soar, and corporate credit markets would be closed to all but the highest quality issuers. We envisage that consumers and businesses would likely stop spending on all but essential items, and the value of the dollar would drop by 10% or more against other major currencies. With the dollar heading lower, investors would likely look for hard assets like oil and other commodities, driving prices higher.
Even if Washington did raise the debt ceiling after just a few harrowing days following a default, and financial markets gradually reopened to the extent that the Treasury would be able to issue debt (but at higher interest rates), we envisage that the economy could fall quickly back into recession.
Under these hypothetical conditions, public finance issuers would very likely suffer, as liquidity became a crucial issue in staving off default, with direct loans, refinancing, and any market-sensitive debt becoming very difficult, if not impossible, to refinance.
We expect that financial institutions would similarly suffer in this scenario, given our expectation of a systemic and global macroeconomic disruption where liquidity becomes a critical issue potentially exacerbated by confidence sensitive liabilities. In short, we could revisit the fall of 2008, when a complete loss of investor confidence and a massive flight to quality brought the global funding markets to a temporary stand-still. The greatest impact would likely be on the inability to roll-over maturing debt and asset-backed securities, the reluctance of repo counterparties to accept certain collateral, and contingent liability requirements being triggered. U.S. financial sectors such as banks, funds, finance companies, exchanges/clearinghouses, broker dealers, and life insurance companies whose business models are partially dependent (and for some highly dependent) on short-term funding would experience, in our view, the most immediate ratings impact.
In our view, financial market turmoil could be worsened should money market funds "break the buck". Money market funds issue and redeem shares at $1.00 provided that their marked-to-market net asset value (NAV) per share is between $0.995 and $1.005. Given this very small margin of error, deviations of greater than plus-or-minus 0.5% can create a situation in which a fund sells and redeems shares at a price other than $1.00, or, in other words, "breaks the buck." Should a market disruption caused by an 'SD' rating event lead to a decline in the prices of U.S. Treasury and Government securities (and other short-term money market instruments), money market funds may experience a precipitous drop in their NAVs, increasing the likelihood of money funds breaking the buck and facing massive redemption requests.
Among corporate borrowers, we expect this scenario would likely have the greatest impact on those nearer the bottom of the ratings scale, as well as on those companies with immediate working capital needs or the need to refinance obligations in a short time. The long-term effects of a protracted default and, correspondingly, the impact on the global economy and financial system, would be of major concern.
Given the likelihood, in our view, that a selective default, were it to occur, would persist for only a short time, we expect that ratings actions on structured finance securities would be limited to those with payments due in the near term and those that fail to make payments within any grace period in accordance with our criteria. We would likely lower our ratings on these to 'D (sf)' until the relevant payment defaults were cured. If a government default persisted for a longer period, we would use the same approach in rating transactions exposed to maturing U.S. obligations such as defeased securities, for example.
Europe: More Vulnerability, More Risk
Standard & Poor's believes the effects of a downgrade or default of U.S. sovereign debt, if it were to occur, would be felt around the world.
In Europe, we believe any additional stresses caused by a protracted standoff in the U.S. would likely amplify already tense market conditions in Europe in light of significant fiscal imbalances in Greece, Portugal, and Ireland. However, the impact would vary greatly, depending on the particular scenario.
If hypothetical scenario 1 were to occur, we believe the effect in Europe of an agreement to raise the debt ceiling and implement credible deficit-reduction measures would be minimal and limited to any potential spillover effects of a sluggish U.S. economy on global trade. In the short term, a resolution would likely support the dollar against the euro, which would help European exports.
Similarly, an agreement to raise the debt ceiling, but postpone a deficit-reduction plans would, in our view, have slightly larger--though still small--European consequences. We believe this scenario would likely boost the euro, which would hurt competitiveness in the most-exposed economies of the euro zone--i.e., Portugal, Spain, and Ireland. More specifically, this scenario could potentially result in negative ratings actions for insurers with large U.S. operations or exposure to U.S. sovereign investments.
Clearly, a default by the U.S. government--i.e., hypothetical scenario 3--could be substantially more serious--reminiscent, in fact, of late 2008. In contrast with then, however, most European countries are today in a far weaker fiscal position and, in our view, less able to provide substantive economic stimulus.
Standard & Poor's believes that in such a scenario, central banks in Europe would send strongly supportive signals to the financial sector in an effort to stave off any panic. Still, access to the interbank market in Europe would likely be reduced, and investors' risk aversion would likely extend to the most confidence-sensitive issuers (such as banks, particularly those with significant operations in the U.S.), highly leveraged borrowers (companies resulting from leveraged buyouts, CMBS), and sovereigns that are already under considerable fiscal stress.
Asia-Pacific: Contagion And Consequences
Across the Asia-Pacific region, we believe the potential market disruption associated with a downgrade or default of U.S. sovereign debt--including damaged market sentiment, the potential for dislocation of funding markets, and the disruption of capital flows--would be more meaningful than the direct financial impact. We believe the robust economic growth outlook for Asia-Pacific, strong domestic savings rates, and healthy household and corporate sectors would likely mitigate ratings pressures. However, a state of prolonged uncertainty or a drawn-out showdown could result in negative actions on sovereign ratings in Asia-Pacific.
While China and Japan are large holders of U.S. debt securities, the immediate disruption in global markets of a U.S. default would be unlikely to cause a substantial hike in official interest rates in either country, in our view, assuming the authorities respond quickly to maintain confidence. In fact, we expect both would likely see large repatriations of funds as part of a flight-to-quality, which to a degree should help the largest banks. Smaller institutions could suffer if governments don't provide explicit support for them, as was the case in 2008-2009. The yen and yuan could experience sharp upward pressures, and China would likely launch another stimulus package to bolster economic expansion, while the Japanese government, with weaker control over its economy and high debt, would be unlikely to sustain growth, in our view.
We think the immediate effect on the Asia-Pacific financial sector would be a rise in spreads that would raise the funding costs of Australian, Korean, and Japanese banks that have some dependence on offshore funding markets. A broader swath of banks and insurers would also likely feel the impact through declines in the market values of their assets (mark to market accounting) and pressure on their market-dependent income.
The direct effects on corporate borrowers would likely be limited, in our view, but market disruptions could result in reduced liquidity and a heightening of refinancing risk in the near term. Given the interconnectivity of the global markets, this could hurt market sentiment, and capital and liquidity flows--having the biggest impact among leveraged entities seeking to roll over debt or get new funding.
Latin America: Substantial Ties, Substantial Impact
We expect that the Latin American region would be hard hit by a U.S. downgrade or default, with the magnitude depending on the duration of the global disruption, especially with regard to liquidity flows and heightened risk-aversion. Further, the ramifications to the economies of Mexico, Central America, and the Caribbean, where trade, remittance, and tourism-related links to the U.S. are substantial, would reverberate even more significantly than elsewhere in the region, in our view.
Assuming that any default is only temporary, several factors could reduce its effects. Overall financing needs are relatively low in both the corporate and government sectors in this region. Also, the banking systems depend largely on local deposits. While it remains unclear where risk-aversion would lead money to flow, we think outflows from Latin banks would be unlikely. Finance companies could be susceptible to liquidity shortages, given their relatively high short-term debt market funding needs and the potential for banks to close credit lines.
Meanwhile, international reserves have grown, affording what we consider to be a significant cushion that complements the flexibility provided by the floating exchange rates in most countries. And central banks are still, on balance, in a tightening phase with regard to monetary policy--a trend that central banks could simply reverse or stall, even while remaining focused on their inflation targets over the long-term. Finally, we anticipate the region's central banks would reinstate the facilities they put in place to provide liquidity to the local markets when global capital markets seized up in 2008-2009.
In our view, the need for an agreement to raise the debt ceiling before it is breached--which the government has said would occur on or around Aug. 2--remains a major risk to the U.S. economy, in our view. Because we see a real risk that efforts to reduce future deficits may meaningfully miss the targets that Congressional leaders and the White House have discussed, we put the likelihood that we would lower the long-term rating on the U.S. within the next three months and potentially as soon as early August--by one or more notches, into the 'AA' category--at about 50-50.
There is some concern that investors, especially those overseas, are speculating that the U.S. government would resort to higher inflation to reduce the real value of its debts. Given the risks of a government shutdown, some feel the Fed would need to keep policy "too easy, too long" in order to accommodate whatever happens on the fiscal side. But the central bank has said it understands the dangers of this kind of action, with Chairman Ben Bernanke arguing that it's "an outcome that should be avoided at all costs."
We believe it unlikely that the Fed would sit on its hands if fiscal inaction or irresponsibility destabilized the recovery. If an aggressive dose of austerity hurts growth and brings back the risk of deflation--or if market liquidity begins to dry up--we think the Fed would likely step in to provide support to the markets and offer another round of quantitative easing.
Collaboration on substantial spending cuts appears to be within reach, though we see demands that spending be trimmed by as much as the increase in the debt limit as a potential stumbling block. Still, we expect that cooler heads will prevail in the end, and Washington will avert a default. The consequences of not doing so would simply be too severe, in our view.
Writer: Joe Maguire
|Sovereign Ratings:||David T Beers, Managing Director, London (44) 20-7176-7101;|
|Fixed Income Analytics:||Beth Ann Bovino, Senior Economist, New York (1) 212-438-1652;|
|Ratings Quality:||Curtis Moulton, Managing Director, New York (1) 212-438-2064;|
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