Government

3 Reasons A Downgrade Might Not Be A Big Deal (And 1 Big Reason It Might)

In the past few days, the prospect of a default by the U.S. has gotten tangled up with the prospect of a downgrade of America's credit rating. It's worth pulling these two possibilities apart.

It's widely agreed that a default would be a very big deal and could cause huge economic problems. There also still seems to be pretty broad agreement — even at this late date (which may not be quite as late as we thought) — that a default is unlikely.

So let's assume for purposes of this post that the U.S. does not default, and that Congress and President Obama work out a deal that allows the U.S. to keep paying its bills.

It's still very possible that one or more rating agencies would downgrade America's credit rating, from AAA to AA (or AA+) — not because of worries about the country's ability to pay its debt in the short term but because of more long-term worries.

Would a downgrade be a big deal? Maybe not.

The central question is what would happen to the interest the U.S. pays on its debt. Because the interest rate on lots of consumer debt (like mortgage loans) is tied to the interest on government debt, a rise in government interest rates could have broad ripple effects.

But there are a few reasons to think the effect of a downgrade might be small:

1. The vast majority of U.S. debt is held by big institutions like pension funds and central banks. Those institutions do their own research on sovereign debt, and don't tend to be heavily influenced by rating agencies, Amitabh Arora, a researcher at Citigroup, told us this week. Arora co-authored a Citi report that found a 50-50 chance of a downgrade — and that a downgrade in the absence of a default would have "little impact on Treasury yields."

2. Ratings are a factor in financial-industry regulations and in internal policies at financial institutions. But almost all of these regulations and policies treat a AAA rating the same as a AA rating. So a downgrade from AAA to AA would trigger little or no forced selling, Arora said. An official at Vanguard, the big mutual fund company, told me this week that "a downgrade from AAA would not trigger any events inside our funds."

3. When other countries were downgraded from AAA to AA, the effect was minimal in most cases, according to this this report from AllianceBernstein. Japan, for cexample, was downgraded in 2009, to little effect. When Canada was downgraded in 1994, its interest rates briefly went up by half a percentage point — but two months later, rates had come back down to where they were before the downgrade. (Canada later regained its AAA rating, by the way.)

* Why a downgrade might be a big deal: There's ultimately no telling what investors would do in case of a downgrade. It certainly has a nasty ring to it, and we sure thought it would be a big deal when we first heard about the possibility a few months back.

Reaction might come not only in the bond market but also in the stock market, if a downgrade spooked investors about the U.S. economy. Mohamed El-Erian, the chief economist at Pimco, describes out a high-impact scenario:

"A downgrade would mean a weaker dollar, somewhat higher interest rates and a further blow to the already fragile national economic confidence," El-Erian told the NYT. "This translates into weaker growth and even greater headwinds when it comes to job creation, which is absolutely critical at this stage."

For More:

Here's recent coverage of the downgrade issue from NPR, the NYT, Bloomberg and Politico.

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