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Moody's Turns Screws On Washington; Eyes Downgrade Of U.S. Debt

Only a few years ago, it was federal policymakers who were turning the screws on Moody's Investors Service and the other Wall Street ratings agencies for mislabeling subprime investments as relatively risk-free.

Now Moody's is returning the favor. The ratings agency announced after the New York financial markets closed that it had placed the vaunted triple A rating of U.S. treasuries under review for a possible downgrade.

An excerpt from Moody's release:

New York, July 13, 2011 — Moody's Investors Service has placed the Aaa bond rating of the government of the United States on review for possible downgrade given the rising possibility that the statutory debt limit will not be raised on a timely basis, leading to a default on US Treasury debt obligations. On June 2, Moody's had announced that a rating review would be likely in mid July unless there was meaningful progress in negotiations to raise the debt limit.

In conjunction with this action, Moody's has placed on review for possible downgrade the Aaa ratings of financial institutions directly linked to the US government: Fannie Mae, Freddie Mac, the Federal Home Loan Banks, and the Federal Farm Credit Banks. We have also placed on review for possible downgrade securities either guaranteed by, backed by collateral securities issued by, or otherwise directly linked to the US government or the affected financial institutions.

The review of the US government's bond rating is prompted by the possibility that the debt limit will not be raised in time to prevent a missed payment of interest or principal on outstanding bonds and notes. As such, there is a small but rising risk of a short-lived default.

Moody's considers the probability of a default on interest payments to be low but no longer to be de minimis. An actual default, regardless of duration, would fundamentally alter Moody's assessment of the timeliness of future payments, and a Aaa rating would likely no longer be appropriate. However, because this type of default is expected to be short-lived, and the expected loss to holders of Treasury bonds would be minimal or non-existent, the rating would most likely be downgraded to somewhere in the Aa range.

That was the stick. Moody's offered a bit of a carrot for policymakers to gnaw on as well. If the Obama Administration and Congress can arrive at a credible deficit-reduction package, not only would the ratings agency keep the U.S. at triple A, but it wouldn't place a negative outlook on U.S. debt. Standard & Poor's has already given the U.S. a negative outlook.

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