US credit rating downgrade fuels crisis

The United States was reeling today after Standard & Poor's lowered the nation's AAA credit rating for the first time since granting it in 1917.

The move came less than a week after a gridlocked Congress finally agreed to spending cuts that would reduce the debt by more than two trillion dollars (£1.2tn) - a tumultuous process that contributed to convulsions in financial markets. But the promised cuts were not enough to satisfy credit rating agency S&P.

The drop in the rating by one notch to AA-plus was telegraphed as a possibility back in April. The three main credit agencies, which also include Moody's Investor Service and Fitch, had warned during the budget fight that if Congress did not cut spending far enough, the country faced a downgrade.

Moody's said it was keeping its AAA rating on the nation's debt, but that it might still lower it.

One of the biggest questions after the downgrade was what impact it would have on already nervous investors.

While the downgrade was not a surprise, some selling is expected when stock trading resumes on Monday. The Dow Jones industrial average fell 699 points this week, the biggest weekly point drop since October 2008.

"I think we will have a knee-jerk reaction on Monday," said Jack Ablin, chief investment officer at Harris Private Bank.

But any losses might be short-lived. The threat of a downgrade is likely already reflected in the plunge in stocks this week, said Harvey Neiman, a portfolio manager of the Neiman Large Cap Value Fund.

"The market's already been shaken out," Mr Neiman said. "It knew it was coming."

One fear in the market has been that a downgrade would scare buyers away from US debt. If that were to happen, the interest rate paid on US bonds, notes and bills would have to rise to attract buyers. And that could lead to higher borrowing rates for consumers, since the rates on mortgages and other loans are pegged to the yield on Treasury securities.

However, even without an AAA rating from S&P, US debt is seen as one of the safest investments in the world. And investors clearly were not scared away this week.

While stocks were plunging, investors were buying Treasurys and driving up their prices. The yield on the 10-year Treasury note, which falls when the price rises, fell to a low of 2.39% on Thursday from 2.75% on Monday.

A study by JPMorgan Chase found that there has been a slight rise in rates when countries lost an AAA rating. In 1998, S&P lowered ratings for Belgium, Italy and Spain. A week later, their 10-year rates had barely moved.

The government fought the downgrade. Administration sources familiar with the discussions said the S&P analysis was fundamentally flawed. They spoke on condition of anonymity because they were not authorised to discuss the matter publicly.

S&P had sent the administration a draft document in the early afternoon yesterday and the administration, after examining the numbers, challenged the analysis.

S&P said that in addition to the downgrade, it is issuing a negative outlook, meaning that there was a chance it will lower the rating further within the next two years.

It said such a downgrade, to AA, would occur if the agency sees smaller reductions in spending than Congress and the administration have agreed to make, higher interest rates or new fiscal pressures during this period.

In its statement, S&P said that it had changed its view "of the difficulties of bridging the gulf between the political parties" over a credible deficit reduction plan.

S&P said it was now "pessimistic about the capacity of Congress and the administration to be able to leverage their agreement this week into a broader fiscal consolidation plan that stabilises the government's debt dynamics any time soon."

The Federal Reserve and other US regulators said in a joint statement that S&P's action should not have any impact on how banks and other financial institutions assess the riskiness of Treasurys or other securities guaranteed by the US government.

The statement was issued to make sure banks did not feel that the downgrade would affect the amount of capital that regulators require the banks to hold against possible losses.

Before leaving for a weekend at Camp David, President Barack Obama met treasury secretary Timothy Geithner in the Oval Office late Friday afternoon.

The downgrade is likely to have little to no impact on how the United States finances its borrowing, through the sale of Treasury bonds, bills and notes. This week's buying proves that.

"Investors have voted and are saying the US is going to pay them," said Mark Zandi, chief economist of Moody's Analytics. "US Treasurys are still the gold standard."

He noted that neither his parent organisation, Moody's, nor Fitch, the other of the three major rating agencies, have downgraded US debt.

Japan had its ratings cut a decade ago to AA, and it did not have much lasting impact. The credit ratings of both Canada and Australia have also been downgraded over time, without much lasting damage.

"I don't think it's going to amount to a lot," said Peter Morici, a University of Maryland business economist.

Still, he said, "The United States deserves to have this happen" because of its clumsy handling of fiscal policy.