It is now close to three weeks since Standard & Poor's lowered its rating on U.S. debt from AAA to AA+ and we now have had sufficient time to evaluate both the downgrade and the aftermath.
Let's start with the downgrade. In its statement, S&P indicated that the downgrade reflected". . . our opinion that the fiscal consolidation plan that Congress and the Administration agreed [upon] . . . falls short of what would be necessary . . ." to stabilize the government's medium-term debt dynamics. The statement went on to state that the ..."effectiveness, stability and predictability of American policymaking and political institutions have weakened..."
One can conclude quite readily that the downgrade was a judgment on the stewardship, and not on the capacity of our federal government. Certainly that was the market reaction, as in the weeks following the downgrade money continued to pour into Treasuries, driving prices to new recent highs and yields to new recent lows.
That does not mean, however, that the downgrade is without consequence. The AA+ rating is still a strong rating, and as the alternatives for sovereign debt instruments do not offer many choices of AAA ratings, for most investors U.S. Treasuries will continue to command much of the market. But there still may be longer-term consequences. This downgrade is a reflection on the governance of our fiscal affairs. The Congress and our current administration came dangerously close to causing a temporary default by using the debt ceiling adjustment as a vehicle for achieving agreement on long-term fiscal issues.
The goal of reducing deficits is laudable, but using the debt ceiling as a bargaining chip was to flirt with default. As bankers, we understand that circumstances can sometimes conspire to leave individuals, businesses, and even sovereign nations unable to meet financial obligations. It is quite another matter when the default occurs as a result of political wrangling and not financial capacity. So the downgrade based on a lapse of stewardship should not have been unexpected. Also, the downgrade reflected the sentiment of many foreign financial officials. Interest rates now are sufficiently low that we do not feel the financial impact of the downgrade, but as interest rates recover and the lower S&P ratings persist, the additional interest cost will be in the millions if not billions.
Another issue raised by the downgrade is the relative importance we assign to credit ratings and credit rating agencies. The recent performance of credit rating agencies on mortgage-backed obligations and other collateralized debt obligations has been less than stellar. That fact has been well publicized and carefully examined, but another dimension of the issue involves the manner in which the credit markets have allowed the rating agencies to dominate credit underwriting.
Credit ratings, which are "point in time" evaluations, have become substitutes for more in-depth credit evaluations or ongoing credit updates. I am personally guilty of falling into that pattern. Recently I was asked about the strength of a corporate debt obligation and the full extent of my guidance was to ask for the credit rating. As a result of our recent experience with rating instruments, I will no longer be willing to take comfort only in the rating agency evaluation. Over the past several decades credit ratings have become common requirements of corporate, municipal, and state underwritings. The rating agency imprimatur determined the interest rate at which the instruments would be issued and also determined the acceptability of the instruments for inclusion in many portfolios.
Regulators also found the ratings convenient. Ratings, in some cases, determined the risk rating for risk-based capital purposes as determined by bank regulators. The Securities and Exchange Commission also expected to see minimum rating requirements for certain corporate underwritings.
So, what lessons have we learned from the credit downgrading experience? I think there are several.
First, it will be many years until the obligations of the United States government are considered the gold standard of creditworthiness for sovereign debt.
Second, this should be a warning to policy makers that our fiscal stewardship will be monitored along with our fiscal capacity, and that the markets will be looking for evidence that we as a nation are willing to address the long term budget issues that for years have been kicked down the road.
Third, it is a reminder that the role of credit rating agencies has changed — probably forever — and that the rating provided by a rating agency should be viewed as only one data point. Agency ratings will no longer be a substitute for individual purchaser analysis of creditworthiness.
Finally, as the recent experience has shown, U.S. treasury instruments will continue to be sought in both domestic and international markets because of the depth and stability of the market for these obligations. However, we have received a warning that the markets will not tolerate continual postponement of facing fiscal reality by our policymakers in Washington DC.
Mark W. Olson has served as a Federal Reserve Board governor, chairman of the PCAOB and chairman of the American Bankers Association. He currently serves as co-chairman of Treliant Risk Advisors LLC and can be reached at
