What does S&P's downgrade mean for you?
OPINION - There's no right answer -- the downgrade may suddenly strike the economy or linger for years, like a virus...
Standard & Poor’s downgraded the United States’ credit rating on Friday evening, ending speculation that mounting budget deficits and political gridlock would have unprecedented repercussions. Nobody knows for certain how the markets will react, other than the obvious, that three decades of reckless fiscal policies and 30 second sound bites of damnation have consequences.
It’s important to understand that bonds are rated according to their ability to return an investors’ principal and make all agreed upon interest payments in a timely manner. While a consumer’s credit worthiness is measured by Equifax, TransUnion and Experian, the United States is subject to the rating agencies Fitch, Moody’s and Standard & Poor’s.
The recent debt ceiling debate shed light on the unsustainable debt projections faced by the U.S. treasury. The United States currently owes over $14.5 trillion and is forecasted to reach $24 trillion in ten years, an amount that would make the Greek parliament blush. This unflattering portrait prompted warnings from Standard & Poor’s, cautioning us that unless we reduced spending or increased revenue by $4 trillion in a debt ceiling compromise, they would strip us of our coveted AAA credit rating.
Lo and behold, Congress exposed a dysfunctional political system and didn’t reach agreement on a credible path to a balanced budget, instead choosing to cut spending by only $2.4 trillion. Failure to act responsibly forced Standard & Poor’s to sound the siren of contempt, having misjudged the risks posed by mortgage backed securities that caused the crisis of 2008, and reduced our rating to AA+.
Please note that investors and central banks were aware of this possibility and likely priced the imposing threat into the market. Moreover, the U.S. dollar is the reserve currency, such that treasury bonds are the bedrock of the global economy. Whenever the financial markets experience violent bouts of volatility, U.S. government bonds seem to be in great demand, even if our debt (or banking system) served as the catalyst.
Having said that, interest rates compensate investors for the amount of risk they assume, and a credit downgrade exposes them to outcomes not previously incorporated into the original transaction. Just as the mortgage rates rise for home-buyers with low credit ratings, the United States may find itself in the same position. For every .6 percent increase in the Treasury bond rate, the United States treasury will pay an additional $100 billion every year in interest expenses, increasing the current budget deficit by roughly seven percent.
Keep in mind that consumers would also suffer accordingly, as mortgage rates are based on the ten-year treasury bond, auto loans are predicated on the two-year treasury and credit cards rely on the federal funds rate — everyone could be pay the price. Consumer spending is 70 percent of our economy, such that higher borrowing costs would thwart the much-speculated economic recovery.
It remains to be seen if the fallout will be catastrophic. What we do know is the credit downgrade is a precursor to future indictments if Congress doesn’t act. The United States may owe $14.5 trillion today, but it faces over $60 trillion in unfunded liabilities, due mainly to entitlement benefits promised to an aging population. In fact, Congress needed to cut spending or increase revenue by $15 trillion over the next decade just to maintain the same debt to GDP ratio for the foreseeable future.
This story is still being written. Congress may see this as a wake-up call and engage in healthy discussions about what is possible. Failure to pursue fiscal responsibility, however, would invite a sovereign debt crisis with broader implications. There’s no right answer — the downgrade may suddenly strike the economy or linger for years, like a virus. We’ll all know soon enough; time seldom keeps secrets.
