America’s credit rating in jeopardy

WASHINGTON – An unexpected warning by a major credit agency on America’s soaring debt shocked global investors and threatened still wider consequences for the U.S. economy, even as a new sense of realism emerged in the stalemate between President Barack Obama and congressional Republicans over fiscal policy.

The warning came in the form of a downgrade by an independent credit agency in its assessment of the deficit problem. Standard & Poor’s said Monday there was a 1-in-3 chance that it would lower the Treasury Department’s now-sterling AAA credit rating on U.S. debt in the next two years.

The forecast alone could drive interest rates higher and impose new strains on consumers and the still-fragile economic recovery.

The White House dismissed the rating agency’s move as a “political” gesture that failed to recognize America’s long history of political opponents coming together in times of crisis. And, after weeks of often bellicose sparring, there were signs that just such an edging together might be under way – at least on the most immediate issue of raising the debt ceiling.

Until a few days ago, some prominent conservative Republicans – including some House members – had been questioning whether it was necessary to raise the debt ceiling. Others had talked of holding a debt ceiling bill hostage to further concessions from Democrats on deficit reduction.

In recent days, however, both Obama and GOP congressional leaders issued pledges to get the ceiling raised in a timely fashion. Obama acknowledged that an agreement would entail new commitments on deficit reduction, and Republicans promised to find common ground even though they still have huge differences with Democrats on spending and taxes.

Stocks fell sharply on the S&P report, with the Dow Jones industrial average losing nearly 250 points in early trading before recovering to close down 140 points at 12,201.59. The S&P 500 was down 14.54 points to 1,305.14, and the Nasdaq fell 29.27 points to 2,735.38. All three indexes fell about 1.1 percent.

Here’s a deeper look at what this is all about.

Q.What is Standard & Poor’s, and why does its opinion matter?

A.S&P is a nationally recognized statistical rating organization. It rates debt, in this case U.S. Treasury bonds, in terms of the risk of default they pose to investors in them. U.S. government securities have long enjoyed the top AAA rating but are now viewed as at risk for a downgrade of creditworthiness.

Q.Why would a downgrade affect borrowing costs in the economy?

A.The ratings issued by S&P and its main competitors – Moody’s Investors Service and Fitch Ratings – are used by investors to calculate what sort of return they should demand in exchange for the default risk they assume when investing in a given security. A lower rating means a higher chance of default.

The issuer, in this case the U.S. government, would have to pay a higher interest rate to investors to market its lower-rated bonds. Since the government must borrow to pay off existing debt, the cost of that would snowball into an even more costly fix for our fiscal problems.

Q.How would that affect me?

A.Mortgage interest rates are often pegged to prevailing rates for U.S. government securities, as are other borrowing rates. If your 401(k) retirement plan invests in bonds, you might get returns from rising bond rates. This was reflected in the marketplace on Monday as the interest rate on bonds crept up and stocks lost value.

But rising borrowing rates choke off economic growth. If there’s no political compromise in Washington on taming future deficits, that would be bad for the U.S. economy. And if there is a compromise, it is likely to entail austerity measures that slow economic growth.

Q.But lawmakers will reach agreement eventually, won’t they?

A.The two political parties are very far apart. Their differences are rooted in deep philosophical disputes over the role of government in society. It’s quite possible there will be no significant deal on resolving federal finances until after the 2012 elections, and then only if one side gains significant strength.

S&P analysts pointed to ongoing fiscal austerity efforts in France and Great Britain and questioned the lack of similar government financial discipline in the United States.

“We believe there is a material risk that U.S. policymakers might not reach an agreement on how to address medium- and long-term budgetary challenges by 2013; if an agreement is not reached and meaningful implementation does not begin by then, this would in our view render the U.S. fiscal profile meaningfully weaker than that of peer ‘AAA’ ” nations, S&P analysts wrote Monday.

Q.Was the S&P action totally a surprise?

A.No. In February, PIMCO, the world’s largest bond investment fund, announced it was selling off its U.S. government debt because it didn’t think the return on investment properly reflected the risks of holding U.S. debt. Earlier this month, PIMCO began actually betting against U.S. debt. In a sense, big players in the bond market got ahead of the ratings agencies, which they depend on for guidance.

S&P “should have made this move a long time ago,” said Steven Ricchiuto, the chief economist for Mizuho Securities USA in New York. “Let’s be honest. Ireland, Portugal, the (debt) issues of Spain are nothing more than a warm-up for what’s in play here … if something doesn’t happen, it’s going to be ‘how many warnings do you have to send somebody before they pay attention.’ ”

Q.How big are our deficits and debt?

A.The nation’s debt held by the public on Monday totaled $9.67 trillion, while the debt the federal government owes itself stands about $4.6 trillion. The total public debt outstanding stood at $14.3 trillion. The deficit – the shortfall between what government collects in revenues and what it spends in a given year – is projected to come in around $1.6 trillion for the current fiscal year, which ends on Sept. 30.

Q.What are the prospects for a budget deal?

A.The first real indication may come next month, when the U.S. likely will reach its current $14.3 trillion debt limit. Congress must raise the legal limit on how much the U.S. can borrow, and unless it does so, the U.S. won’t be able to pay its creditors. That would sow financial chaos worldwide, as U.S. bonds are globally regarded as one of the world’s safest investments.

Q.Why does this matter to the broader debt debate?

A.Republicans, pushed by conservative tea party activists, oppose a “clean” bill that does nothing more than raise the debt ceiling. They hope to extract from Democrats and the Obama administration deeper spending cuts and progress on a long-term deficit-reduction plan as their price for going along with raising the government’s debt limit. Most Democrats oppose the GOP’s approach.

“There is bipartisan opposition in the Senate to raising the debt ceiling unless we do something significant about the debt,” said Senate Republican leader Mitch McConnell, R-Ky. “And in terms of what is significant, in my view, the definition of significant is what we do is viewed as credible by the markets, by the American people, and by foreign countries.”