S&P Says Likelihood US Is Downgraded To AA As Soon As Early August Is 50-50

S&P Says Likelihood US Is Downgraded To AA As Soon As Early August Is 50-50: "

A rather sobering report out from S&P, which has no other function than to tighten the screws even more on those who prudently are holding out against extending the debt ceiling. As for S&P: please explain to US how 120% debt/GDP is better than 100% debt/GDP, and thus more worthy of a AAA rating? Please. Because we must be bloody stupid.

The U.S. Debt Ceiling Standoff Could Reverberate Around The Globe--With Or Without A Deal

As the Obama Administration and congressional Republicans continue to
struggle over raising the government's debt ceiling, Standard &
Poor's Ratings Services believes that the reverberations of the showdown
may be deep and wide--particularly if Washington does not come to a
timely agreement on the debt ceiling.

Our analysts have considered three hypothetical scenarios that could
emerge, and we plan to publish articles today detailing our views on the
potential effects of each on the financial services industry, corporate
borrowers, structured finance, public finance borrowers, as well as
economies and markets around the world. The scenarios are as follows:

• Scenario
  1--The White House and Congress agree to raise the debt ceiling and
  collaborate on a long-term framework for fiscal consolidation;
• Scenario
  2--The White House and Congress agree to raise the debt ceiling to
  avoid potential default but are not able to formulate what we consider
  to be a realistic and credible fiscal consolidation plan;
• Scenario
  3--The White House and Congress cannot agree to raise the debt ceiling
  by their Aug. 2 deadline, and the Treasury begins to sharply reduce
  spending to preserve cash for debt service and to try to keep within the
  debt ceiling. Such measures could conclude, if the standoff persisted
  for just a short while, with the Treasury missing an interest payment or
  failing to pay off maturing debt, i.e. a default.

On July 14, Standard & Poor's placed its 'AAA' long-term and 'A-1+' short-term sovereign credit ratings on the United States of America
on CreditWatch with negative implications, reflecting our view of two
issues: the failure to date to raise the debt ceiling so as to ensure
that the federal government will be able to make scheduled payments on
its debt, and our growing concerns about the likelihood that Washington
will agree upon a credible, medium-term fiscal consolidation plan in the
foreseeable future. (See 'United States Of America 'AAA/A-1+' Ratings Placed On CreditWatch Negative On Rising Risk Of Policy Stalemate,' published July 14, 2011.)

While there has been considerable political posturing over the
debt ceiling and related issues, credible indication that the government
will tackle the problem is important to our evaluation of the U.S.'s
creditworthiness. We have previously stated our belief that there is a
material risk that efforts to reduce future budget deficits will fall
short of the targets set by Congressional leaders and the
Administration. In this light, we see at least a one-in-two likelihood
that we could lower the long-term rating by one or more notches on the
U.S. within the next three months and potentially as soon as early
August--into the 'AA' category--if we conclude that Washington hasn't
reached what we consider to be a credible agreement to address future
budget deficits.

It's unclear whether reaching the debt ceiling
would cause the U.S. to immediately default on its debts--the answer
depends on the Treasury's willingness and ability to prioritize debt
service while implementing steep cuts elsewhere. While possible and
riskier as the days pass, we still believe a default is unlikely. We
think it more probable that an 11th-hour deal will be reached. As
Winston Churchill once remarked, "The Americans can always be counted on
to do the right thing…after they've exhausted all other possibilities."

In
the interim, further delay in reaching agreement on the debt ceiling
will likely continue to cause volatility in global financial markets and
may begin to put upward pressure on Treasury yields, which as yet
remain historically low. With governments and investors overseas holding
large amounts of the almost $10 trillion of outstanding U.S. government
debt, foreign selling is a real risk, and an abrupt increase in
long-term borrowing costs would curb U.S. GDP growth--a burden that
economies around the globe would almost certainly soon share.

In
the hypothetical scenarios, we discuss two broad types of implications:
those issuers and issues directly affected or linked to the U.S. rating
and those indirectly affected. Ultimately, the range and severity of
potential rating actions will depend, in our view, on multiple
factors--many of them still unknown. Among these are action on the debt
ceiling, the nature and severity of cuts to the federal budget, and the
subsequent impact on the economy broadly. The most immediate issue is
resolution of the debt ceiling. Inaction on this would, we expect, have a
wide range of economic, budget, liquidity, and capital market
implications across the globe.

Hypothetical Scenario 1--Agreement To Raise The Debt Ceiling And Reduce Debt

If the opposing camps agree to raise the debt ceiling before the
deadline and come to terms on a long-term debt-reduction plan, Standard
& Poor's would likely affirm the U.S. ratings and remove them from
CreditWatch. It is possible, however, that the rating outlook could
remain negative while we evaluate the likelihood that an agreed plan
will be implemented. Ratings of sub-sovereign credits currently on
CreditWatch, including structured financings, would be similarly removed
from CreditWatch and affirmed, and their rating outlooks would mirror
that of the sovereign.

Yet even under this relatively positive
scenario, the resulting fiscal contraction may weigh for many years on
an economy already expected to show below-trend GDP growth given the
still lingering effects of the credit boom and subsequent bust.
Consequently, we believe the economic recovery remains fragile and
vulnerable to external shocks. Moreover, even if Washington does avoid a
default, investor confidence in the dollar, Treasury securities, and
U.S. institutions may suffer lingering effects.

We cannot know
what specifically would be cut from the federal budget, but any
significant slowing of government spending would have generally negative
implications for the economy broadly, in our view, especially for the
corporate and government entities that most depend on federal spending.

For
example, some public finance issuers may suffer in the long-term
because any deal would almost inevitably reduce federal outlays that
currently support ongoing assistance such as Medicaid as well as grants
that support capital projects and research. Lower ratings could result
in some segments of the public sector over time, as federal outlays
shrink and the economy struggles to gain momentum.

At the same
time, in such a scenario, we believe there would likely be little impact
for most financial services entities as this scenario is very close to
our existing base-case economic scenario and is, therefore, already
reflected in our ratings and outlooks.

Any effects on corporate
borrowers would be, in our view, indirect and with some time lag, and
would depend on the fiscal consolidation's impact on the path of
economic recovery.

Hypothetical Scenario 2--Agreement To Raise The Debt Ceiling But No Credible Agreement To Reduce Debt

From a creditworthiness perspective, we believe that failure to
formulate a fiscal consolidation plan, even if the president and
Congress were to agree to raise the debt ceiling in time to avert a
potential default, would be materially less optimal than hypothetical
scenario 1. Such a partial solution would essentially put before
American voters in the 2012 presidential and congressional election the
spending vs. revenue debate. Meanwhile, debt would continue to mount and
the results of the election might not, in any event, resolve the issue.

Under
this scenario, we might lower the U.S. sovereign rating to 'AA+/A-1+'
with a negative outlook within three months and potentially as soon as
early August. We expect that the U.S. transfer and convertibility
assessment would likely remain 'AAA'. We assume that under this scenario
we would see a moderate rise in long-term interest rates (25-50 basis
points), despite an accommodative Fed, due to an ebbing of market
confidence, as well as some slowing of economic growth (25-50 basis
points on GDP growth) amid an increase in consumer and business caution.

Agreement
on raising the debt ceiling without making any tough budget decisions
would not be shocking, in our view, given the number of times Congress
has done so in the past. And while such a move might modestly raise
borrowing costs for the federal government, we view it as relatively
benign for public finance issuers. Maintaining the status quo on federal
outlays--for the year, anyway--would help alleviate some fiscal stress
in the public finance sector, and reduce the prospect of widespread
downgrades until and unless a larger solution was reached that cut
federal outlays significantly.

While banks and broker-dealers
wouldn't likely suffer any immediate ratings downgrades, we would
downgrade the debt of Fannie Mae, Freddie Mac, the 'AAA' rated Federal
Home Loan Banks, and the 'AAA' rated Federal Farm Credit System Banks to
correspond with the U.S. sovereign rating. We would also lower the
ratings on 'AAA' rated U.S. insurance groups, as per our criteria that
correlates insurers' and sovereigns' ratings.

A scenario that
leads to a downgrade of the U.S. government to the 'AA+' level wouldn't
affect the ratings of the four U.S.-based corporate borrowers rated
'AAA'. However, we would lower the ratings on three government-related
entities--the Army & Air Force Exchange Service, the Marine Corps Community Services, and the Navy Exchange Service Command--in keeping with our criteria.

For structured financing transactions, we would assess the degree
of each deal's exposure to U.S. government obligations or guarantees as
part of our analysis of whether to affirm or lower the ratings. We
think that any potential modest rise in interest rates would not
generally affect the ratings of structured finance transactions. We
expect that our ratings on non-affected structured finance transactions
generally would not be affected by a change in the sovereign rating. Our
approach to rating new structured finance transactions, denominated in
U.S. dollars, up to 'AAA', would also not generally be affected.
However, we might see adjustments in the way proposed new structures
address potential changes in interest rate and foreign exchange
scenarios. We also believe that new issuance activity may slow
moderately under this hypothetical scenario due to market reaction.

Hypothetical Scenario 3--No Agreement To Raise The Debt Ceiling, Increasing The Specter Of Default

Clearly, a failure by Washington to raise the debt ceiling and agree
on deficit-reduction measures would lead to significant turmoil--and
could prove severe if such a situation lingered long enough to push the
government into default. Senate Democrats recently quoted Treasury
Secretary Timothy Geithner as saying such a development would be 'lights
out' for the U.S. economy. And while we think this possibility is the
least likely, we find it difficult to disagree that it would wrack
global financial markets and likely shove the U.S. economy back into
recession.

To start, we envisage that in this hypothetical
scenario the Treasury would begin sharply reducing spending to preserve
cash to make interest payments and try to stay within the debt ceiling.
We might also see the Federal Reserve launch another round of
quantitative easing in an effort to be as accommodative as it can. We
think it possible that the Treasury could successfully roll over the $59
billion in maturities due on Aug. 4 and Aug. 11, and could make the
Aug. 3 Social Security payments, while sharply cutting discretionary
spending and delaying payments to state governments, vendors and
contractors, and federal employees.

Under this scenario, we expect
that interest rates could rise--say, 50 bps on short-term rates and
double that on the long end--though this may depend on whether
Treasuries would lose their status as the safe haven that investors have
historically perceived them to be, or whether physical assets such as
gold would benefit from such a flight to quality. Either way, we expect
that corporate borrowers would likely see spreads widen correspondingly,
and equity markets and the dollar would likely suffer.

Under this
hypothetical scenario, we envisage that financial market conditions
would worsen considerably in a matter of days. Failure to pay off
maturing debt or missing interest payments (approximately $62 billion of
interest is payable on Aug. 15) would constitute a selective default
pursuant to our criteria, and Standard & Poor's expects it would
lower the sovereign rating to 'SD'. Even if the Fed and other central
banks managed to keep the financial system functioning, we expect that
markets around the world would be severely damaged. In such a
hypothetical scenario, we expect that equity markets would generally
plunge, borrowing costs and interbank lending rates would soar, and
corporate credit markets would be closed to all but the highest quality
issuers. We envisage that consumers and businesses would likely stop
spending on all but essential items, and the value of the dollar would
drop by 10% or more against other major currencies. With the dollar
heading lower, investors would likely look for hard assets like oil and
other commodities, driving prices higher.

Even if Washington did
raise the debt ceiling after just a few harrowing days following a
default, and financial markets gradually reopened to the extent that the
Treasury would be able to issue debt (but at higher interest rates), we
envisage that the economy could fall quickly back into recession.

Under
these hypothetical conditions, public finance issuers would very likely
suffer, as liquidity became a crucial issue in staving off default,
with direct loans, refinancing, and any market-sensitive debt becoming
very difficult, if not impossible, to refinance.

We expect that
financial institutions would similarly suffer in this scenario, given
our expectation of a systemic and global macroeconomic disruption where
liquidity becomes a critical issue potentially exacerbated by confidence
sensitive liabilities. In short, we could revisit the fall of 2008,
when a complete loss of investor confidence and a massive flight to
quality brought the global funding markets to a temporary stand-still.
The greatest impact would likely be on the inability to roll-over
maturing debt and asset-backed securities, the reluctance of repo
counterparties to accept certain collateral, and contingent liability
requirements being triggered. U.S. financial sectors such as banks,
funds, finance companies, exchanges/clearinghouses, broker dealers, and
life insurance companies whose business models are partially dependent
(and for some highly dependent) on short-term funding would experience,
in our view, the most immediate ratings impact.

In our view,
financial market turmoil could be worsened should money market funds
'break the buck'. Money market funds issue and redeem shares at $1.00
provided that their marked-to-market net asset value (NAV) per share is
between $0.995 and $1.005. Given this very small margin of error,
deviations of greater than plus-or-minus 0.5% can create a situation in
which a fund sells and redeems shares at a price other than $1.00, or,
in other words, 'breaks the buck.' Should a market disruption caused by
an 'SD' rating event lead to a decline in the prices of U.S. Treasury
and Government securities (and other short-term money market
instruments), money market funds may experience a precipitous drop in
their NAVs, increasing the likelihood of money funds breaking the buck
and facing massive redemption requests.

Among corporate borrowers,
we expect this scenario would likely have the greatest impact on those
nearer the bottom of the ratings scale, as well as on those companies
with immediate working capital needs or the need to refinance
obligations in a short time. The long-term effects of a protracted
default and, correspondingly, the impact on the global economy and
financial system, would be of major concern.

Given the likelihood,
in our view, that a selective default, were it to occur, would persist
for only a short time, we expect that ratings actions on structured
finance securities would be limited to those with payments due in the
near term and those that fail to make payments within any grace period
in accordance with our criteria. We would likely lower our ratings on
these to 'D (sf)' until the relevant payment defaults were cured. If a
government default persisted for a longer period, we would use the same
approach in rating transactions exposed to maturing U.S. obligations
such as defeased securities, for example.

Europe: More Vulnerability, More Risk

Standard & Poor's believes the effects of a downgrade or default
of U.S. sovereign debt, if it were to occur, would be felt around the
world.

In Europe, we believe any additional stresses caused by a
protracted standoff in the U.S. would likely amplify already tense
market conditions in Europe in light of significant fiscal imbalances in
Greece, Portugal, and Ireland. However, the impact would vary greatly,
depending on the particular scenario.

If hypothetical scenario 1
were to occur, we believe the effect in Europe of an agreement to raise
the debt ceiling and implement credible deficit-reduction measures would
be minimal and limited to any potential spillover effects of a sluggish
U.S. economy on global trade. In the short term, a resolution would
likely support the dollar against the euro, which would help European
exports.

Similarly, an agreement to raise the debt ceiling, but
postpone a deficit-reduction plans would, in our view, have slightly
larger--though still small--European consequences. We believe this
scenario would likely boost the euro, which would hurt competitiveness
in the most-exposed economies of the euro zone--i.e., Portugal, Spain,
and Ireland. More specifically, this scenario could potentially result
in negative ratings actions for insurers with large U.S. operations or
exposure to U.S. sovereign investments.

Clearly, a default by the
U.S. government--i.e., hypothetical scenario 3--could be substantially
more serious--reminiscent, in fact, of late 2008. In contrast with then,
however, most European countries are today in a far weaker fiscal
position and, in our view, less able to provide substantive economic
stimulus.

Standard & Poor's believes that in such a scenario,
central banks in Europe would send strongly supportive signals to the
financial sector in an effort to stave off any panic. Still, access to
the interbank market in Europe would likely be reduced, and investors'
risk aversion would likely extend to the most confidence-sensitive
issuers (such as banks, particularly those with significant operations
in the U.S.), highly leveraged borrowers (companies resulting from
leveraged buyouts, CMBS), and sovereigns that are already under
considerable fiscal stress.

Asia-Pacific: Contagion And Consequences

Across the Asia-Pacific region, we believe the potential market
disruption associated with a downgrade or default of U.S. sovereign
debt--including damaged market sentiment, the potential for dislocation
of funding markets, and the disruption of capital flows--would be more
meaningful than the direct financial impact. We believe the robust
economic growth outlook for Asia-Pacific, strong domestic savings rates,
and healthy household and corporate sectors would likely mitigate
ratings pressures. However, a state of prolonged uncertainty or a
drawn-out showdown could result in negative actions on sovereign ratings
in Asia-Pacific.

While China and Japan
are large holders of U.S. debt securities, the immediate disruption in
global markets of a U.S. default would be unlikely to cause a
substantial hike in official interest rates in either country, in our
view, assuming the authorities respond quickly to maintain confidence.
In fact, we expect both would likely see large repatriations of funds as
part of a flight-to-quality, which to a degree should help the largest
banks. Smaller institutions could suffer if governments don't provide
explicit support for them, as was the case in 2008-2009. The yen and
yuan could experience sharp upward pressures, and China would likely
launch another stimulus package to bolster economic expansion, while the
Japanese government, with weaker control over its economy and high
debt, would be unlikely to sustain growth, in our view.

We think the immediate effect on the Asia-Pacific financial
sector would be a rise in spreads that would raise the funding costs of
Australian, Korean, and Japanese banks that have some dependence on
offshore funding markets. A broader swath of banks and insurers would
also likely feel the impact through declines in the market values of
their assets (mark to market accounting) and pressure on their
market-dependent income.

The direct effects on corporate borrowers
would likely be limited, in our view, but market disruptions could
result in reduced liquidity and a heightening of refinancing risk in the
near term. Given the interconnectivity of the global markets, this
could hurt market sentiment, and capital and liquidity flows--having the
biggest impact among leveraged entities seeking to roll over debt or
get new funding.

Latin America: Substantial Ties, Substantial Impact

We expect that the Latin American region would be hard hit by a U.S.
downgrade or default, with the magnitude depending on the duration of
the global disruption, especially with regard to liquidity flows and
heightened risk-aversion. Further, the ramifications to the economies of
Mexico, Central America, and the Caribbean, where trade, remittance,
and tourism-related links to the U.S. are substantial, would reverberate
even more significantly than elsewhere in the region, in our view.

Assuming
that any default is only temporary, several factors could reduce its
effects. Overall financing needs are relatively low in both the
corporate and government sectors in this region. Also, the banking
systems depend largely on local deposits. While it remains unclear where
risk-aversion would lead money to flow, we think outflows from Latin
banks would be unlikely. Finance companies could be susceptible to
liquidity shortages, given their relatively high short-term debt market
funding needs and the potential for banks to close credit lines.

Meanwhile,
international reserves have grown, affording what we consider to be a
significant cushion that complements the flexibility provided by the
floating exchange rates in most countries. And central banks are still,
on balance, in a tightening phase with regard to monetary policy--a
trend that central banks could simply reverse or stall, even while
remaining focused on their inflation targets over the long-term.
Finally, we anticipate the region's central banks would reinstate the
facilities they put in place to provide liquidity to the local markets
when global capital markets seized up in 2008-2009.

The Endgame

In our view, the need for an agreement to raise the debt ceiling
before it is breached--which the government has said would occur on or
around Aug. 2--remains a major risk to the U.S. economy, in our view.
Because we see a real risk that efforts to reduce future deficits may
meaningfully miss the targets that Congressional leaders and the White
House have discussed, we put the likelihood that we would lower the
long-term rating on the U.S. within the next three months and
potentially as soon as early August--by one or more notches, into the
'AA' category--at about 50-50.

There is some concern that
investors, especially those overseas, are speculating that the U.S.
government would resort to higher inflation to reduce the real value of
its debts. Given the risks of a government shutdown, some feel the Fed
would need to keep policy 'too easy, too long' in order to accommodate
whatever happens on the fiscal side. But the central bank has said it
understands the dangers of this kind of action, with Chairman Ben
Bernanke arguing that it's 'an outcome that should be avoided at all
costs.'

We believe it unlikely that the Fed would sit on its hands
if fiscal inaction or irresponsibility destabilized the recovery. If an
aggressive dose of austerity hurts growth and brings back the risk of
deflation--or if market liquidity begins to dry up--we think the Fed
would likely step in to provide support to the markets and offer another
round of quantitative easing.

Collaboration on substantial
spending cuts appears to be within reach, though we see demands that
spending be trimmed by as much as the increase in the debt limit as a
potential stumbling block. Still, we expect that cooler heads will
prevail in the end, and Washington will avert a default. The
consequences of not doing so would simply be too severe, in our view.

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