Friday, August 5, 2011

S&P Downgrades U.S. Debt for First Time

By DAMIAN PALETTA

WASHINGTON—A cornerstone of the global financial system was shaken Friday when officials at ratings firm Standard & Poor's said U.S. Treasury debt no longer deserved to be considered among the safest investments in the world.

S&P removed for the first time the triple-A rating the U.S. has held for 70 years, saying the budget deal recently brokered in Washington didn't do enough to address the gloomy long-term picture for America's finances. It downgraded U.S. debt to AA+, a score that ranks below Liechtenstein and on par with Belgium and New Zealand.

The unprecedented move came after several hours of high-stakes drama. It began in the morning, when word leaked that a downgrade was imminent and stocks tumbled sharply. Around 1:30 p.m., S&P officials notified the Treasury Department they planned to downgrade U.S. debt, and presented the government with their findings. But Treasury officials noticed a $2 trillion error in S&P's math that delayed an announcement for several hours. S&P officials decided to move ahead anyway, and after 8 p.m. they made their downgrade official.

S&P said "the downgrade reflects our opinion that the fiscal consolidation plan that Congress and the Administration recently agreed to falls short of what, in our view, would be necessary to stabilize the government's medium-term debt dynamics." It also blamed the weakened "effectiveness, stability, and predictability" of U.S. policy making and political institutions at a time when challenges are mounting.

The downgrade will force traders and investors to reconsider in real time what has been an elemental assumption of modern finance. Since July 14, when Standard & Poor's warned it could downgrade the U.S., analysts have struggled to determine how such a move could affect the financial landscape, given how Treasurys permeate the machinery of Wall Street and the economy.

It is possible the blow in the short run might be more psychological than practical. Rival ratings firms Moody's Investors Service and Fitch Ratings have retained their top-notch ratings for U.S. debt in recent days. And so far, U.S. Treasury bonds have remained a safe haven for investors worried about the health of the U.S. economy and the state of Europe's debt crisis. The pre-announcement spat could further undermine the impact.

But the move by S&P could serve as a psychological haymaker for an American economic recovery that can't find much traction, and could do more damage to investors' increasing lack of faith in a political system that is struggling to reach consensus on even everyday policy items. It could lead to the prompt downgrades of numerous companies and states, driving up their costs for borrowing. Policy makers are also anxious about the hidden icebergs the move could suddenly reveal.

A key concern will be whether the appetite for U.S. debt might change among foreign investors, in particular China, the world's largest foreign holder of U.S. Treasurys. In 1945, foreigners owned just 1% of U.S. Treasurys; today they own a record high 46%, according to research from Bank of America Merrill Lynch.

Some investors believe Treasurys will remain a safe haven in a volatile world, even without a solid triple-A credit rating. Others believe the U.S. will be forced to pay higher interest rates, perhaps about 0.5 percentage points, simply because they are seen as being slightly more risky than before. While only a slight gain, such a jump would increase the cost of a wide array of debt, from a home mortgage to the trillions carried by the U.S. government itself.

Lessons from other countries, such as Canada and Australia, suggest it can take years for a country to win back its AAA rating. At the same time, the economic impact of past downgrades has tended to be larger when multiple firms move to rate a country's debt as more risky as opposed to a single firm acting unilaterally.

The downgrade from S&P has been brewing for months. S&P's sovereign debt team, lead by company veteran David T. Beers, had grown increasingly skeptical that Washington policy makers would make significant progress in reducing the deficit, given the tortured talks over raising the debt ceiling. In recent warnings, the company said Washington should strive to reduce the deficit by $4 trillion over 10 years, suggesting anything less would be insufficient.

Negotiations to reach that threshold collapsed, and political leaders instead agreed to a last-second deal to cut the deficit by between $2.1 trillion and $2.4 trillion, making a downgrade almost unavoidable. When the $4 trillion deal fell apart, some Obama administration officials immediately warned that a downgrade from S&P was a real possibility.

S&P officials conferred with a team from the Treasury Department earlier in the week to talk about the debt plan, and government officials tried to explain its scope. S&P officials ended their briefing with an air of mystery about what they might do, and Treasury officials were braced for an announcement later in the week, people familiar with the matter said.

The full faith and credit of the U.S. was established by Alexander Hamilton's 1790 push to have the fledgling federal government assume and pay back debts states incurred during the Revolutionary War. It has gone largely unquestioned since, with just the occasional hiccup, including a 1979 debt-ceiling argument that delayed a few payments.

Recent demographic and economic changes, in particular the aging population and ballooning health-care costs, have made the long-term U.S. picture an ugly one, a problem exacerbated by a deep recession, which cut tax receipts and prompted a flood of fresh debt-financed spending.

Forging an agreement to tackle these problems has been elusive, with bitter partisan disagreements about tax policy and entitlement programs such as Medicare taking center stage.

The world's desire to invest in U.S. debt has a direct effect on businesses and consumers around the world. Many different types of debt, from the interest rate on a mortgage to the cost of a student loan, are pegged to the price the U.S. government pays to borrow money.

So far, economic turmoil in Europe and other parts of the world has continued to drive investors toward Treasurys, sparing the U.S. from a price usually paid by countries that can't get a handle on their debt problems. The phenomenon has kept interest rates paid on government debt very low, making it relatively inexpensive for the Treasury to finance its large deficits.

As a result of the downgrade, a few money-market funds might have to liquidate some of their Treasury holdings if they have tight rules about owning AAA-rated assets, but most aren't expected to be affected. Banks and insurers are unlikely have to hold significantly more capital against their Treasury holdings, though they could see their own bond ratings suffer.

J.P. Morgan Chase & Co. analysts estimate some $4 trillion worth of Treasurys are pledged as collateral by borrowers such as banks and derivatives traders. If that collateral isn't considered as high quality by lenders, the borrowers could be required to cough up more cash or securities to put the minds of lenders at ease.

That could force investors to sell off other assets to come up with the money. In a worst case scenario, credit markets could seize up, as they did during the Lehman Crisis.

Money-market funds held by millions of Americans hold some $1.3 trillion securities directly or indirectly exposed to Treasury and government agency securities, as well as short-term loans to financial institutions, known as repos, which are backed by Treasurys. Experts say that the downgrade won't force money-market funds to sell. But there are still risks.

If Treasurys tumble in value, funds will be forced to mark down their holdings, raising the potential for some to "break the buck" as the Reserve Primary fund did during the worst of the financial crisis.

—Matt Phillips

Write to Damian Paletta at damian.paletta@wsj.com

United States credit rating downgraded | BUSINESS News

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BRUSSELS (AP) — Stocks around the world tumbled Friday ahead of crucial U.S. jobs figures, continuing a losing streak reminiscent of the aftermath of the collapse of U.S. investment bank Lehman Brothers in 2008.

Growing panic about the debts of big eurozone countries like Italy and Spain, paired with fears the U.S. may be heading back into recession. Jobs figures later could well go a long way to determining whether the U.S. economy is indeed on the point of shrinking again.

The biggest one-day points decline on Wall Street since the 2008 financial crisis Thursday carried into Asian and European markets Friday, taking down oil prices as well, as investors were preparing for a slowdown in demand.

In Europe, major markets were firmly in the red once again, although stocks were regaining some ground from earlier in the day. London's FTSE 100 declined 2.5 percent to 5,260 and Germany's DAX shed 2.1 percent to 6,282. France's CAC-40 lost 0.7 percent to 3,297.

Only Spain's Ibex and Italy's FTSE MIB were in positive territory, with Spanish stocks gaining 0.4 percent while Italian shares were up 0.2 percent, even though figures showed both economies barely grew in the second quarter of the year.

Wall Street was set for a lower open with Dow futures down 0.5 percent at 11,317 while S&P 500 futures fell 0.4 percent to 1,193.

Falling stocks are a sign of diminishing confidence in the global economy and that's being felt in oil prices too. The main New York contract was down a further 79 cents a barrel at $85.84 a barrel, having earlier dipped below $85.

Investors around the world are waiting anxiously for U.S. employment figures this afternoon, which could give a firm indication on whether the world's largest economy is indeed headed for a double-dip recession. Analysts expect payrolls to increase by 85,000 and the jobless rate to remain at 9.2%.

"If we get a strong jobs report, this could be enough to send stock markets higher — the relief rally we are looking for — but given the depth of the economic crisis facing the developed world, I am not sure how long such a relief rally will last," said Louise Cooper, markets analyst at BGC Partners. "A poor number could see further declines."

The protracted debate about raising the debt ceiling in the U.S. and confusion about Europe's strategy to fight its worsening debt crisis have undermined confidence in policy makers' willingness and ability to finally draw a line under the financial troubles that have plagued the Western world for four years.

Disagreements in the U.S. Congress are set to herald more struggles about budget cuts at a time when many economists are calling for economic stimulus, while investors fear that Europe may be overwhelmed by growing troubles in Italy and Spain, the eurozone's third and fourth largest economies.

Eurozone leaders' reluctance to increase the size of their bailout fund and quickly implement changes to its powers, such as giving it the ability to buy up government bonds, have left the currency union without a clear defense against market troubles over the summer.

The European Central Bank on Thursday bought up Irish and Portuguese government bonds, but is reluctant to do the same for Italy and Spain until the two countries have taken additional budgetary measures, the head of Belgian's central bank Luc Coene told Belgian radio station RTBF.

Coene, who sits on the ECB's decision-making board, warned that without stricter rules on debts and deficits the euro was not viable in the long-term.

The single currency regained some of its recent losses Friday, trading up 0.6 percent at $1.4250.

The yield, or interest rate, on Italian 10-year bonds surpassed their Spanish equivalents for the first time since May 2010, indicating that investors are now more worried about Rome's massive debts, the second highest in the eurozone, and its difficult political landscape. Italian 10-year yields were at 6.13 percent, while Spain's traded at 6.11 percent — below records seen earlier in the week but still at levels deemed unsustainable in the long-term.

Earlier in Asia, Japan's Nikkei 225 stock average slid 3.7 percent to 9,299.88 and Hong Kong's Hang Seng dived 4.3 percent to 20,946.14. China's Shanghai Composite Index lost 2.2 percent to 2,626.42.

The dollar edged down to 78.48 yen from late Thursday's 79.02. On Thursday, Japan's government intervened in markets to weaken the yen against the dollar to support exporters. Finance Minister Yoshihiko Noda said authorities acted to protect the economic recovery following the March 11 earthquake and tsunami.

The dollar had fallen as low as 76.29 yen on Monday. It hit a record post-World War II low of 76.25 yen in the days following the March 11 earthquake and tsunami.

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Alex Kennedy in Singapore and Joe McDonald in Beijing contributed.