08.06.2011 original publish date
08.07.2011 UPDATE (bottom)
09.26.2012 replaced broken links
S&P Downgrades U.S. Debt Rating
Original article written by Net Advisor™
One of the three major credit rating agencies, Standard & Poor’s (“S&P”) downgraded the rating on U.S. credit late Friday August 5, 2011 (Source: Wall Street Journal).
This is the first time in U.S. history that the United States government’s credit has ever been downgraded. The U.S.A. established an AAA credit rating in 1917 (Source: Bloomberg).
The rational for the credit downgrade in short:
“We lowered our long-term rating on the U.S. because we believe that the
prolonged controversy over raising the statutory debt ceiling and the related
fiscal policy debate indicate that further near-term progress containing the
growth in public spending, especially on entitlements, or on reaching an
agreement on raising revenues is less likely than we previously assumed and
will remain a contentious and fitful process. We also believe that the fiscal
consolidation plan that Congress and the Administration agreed to this week
falls short of the amount that we believe is necessary to stabilize the
general government debt burden by the middle of the decade.”— Source: Standard & Poor’s, page 3, parr 1. (View the original 8 page S&P report in PDF or share the report link here).
The three major credit ratings agencies including Fitch, Moody’s, and S&P all have previously warned Washington DC to control deficit spending now or risk losing its triple A rating. Prior to this announcement, Fitch and Moody’s reaffirmed the U.S. credit rating with a negative outlook.
U.S. Debt-to-GDP Hits 100%
The U.S government spent $238 Billion just two days after raising the debt ceiling pushing the U.S. Debt-to-GDP to 100% (Sources: Fox News, USA Today). What this means is if you took all the goods and services produced in the U.S. which at time of post was approximately $14.3 Trillion, and then subtract the amount of money the U.S. government owes, approximately $14.3 Trillion the U.S. economy would be technically worthless.
Lets put this in more simpler terms.
Pretend you wanted to get a loan – a home loan, a car loan, something that costs more money that you can really afford to pay in cash, so you borrow the money with interest. Now fill out that credit application and pretend your the U.S. government. The application will show (using easier smaller numbers) the following:
Income $47,000
Debt: $47,000
In finance, a person who owes as much as they make has a debt-to-equity ratio of 1:1. The question is, if you were a bank, would you loan someone who for every dollar they make, they spent a dollar, thus, they don’t have any more income to pay the additional debt the new loan would create?
We published our analysis on the government’s “plan” to reduce the deficit over 10 years. In a word the plan is “garbage” and does not lower the deficit at all. Please see our five part article series on the debt ceiling. We predict the deficit will go significantly higher – upwards of 130% by 2021 from when President Obama took office. The only thing that will change this is if entitlements and other spending are reformed, and such reforms are not made with Washington’s hooky math.
Watch for the Spin-Masters
Expect to see the spin-masters come out blaming everyone but themselves. The Liberal Democrats will blame the Republicans because we just aren’t taxing the wealthy enough. The Republicans will blame the Democrats for relentless spending. Others will blame S&P, and say its not that bad.
Quick Look at Reality
1. “According to Internal Revenue Service data, the top 25 percent of earners paid 86.3 percent of federal income taxes while the bottom 50 percent paid 2.7 percent of taxes. Those in the middle paid 11 percent of taxes” (Source: CNBC, 06-30-2011).
2. Obama Deficit to Exceed 8 Years of Bush in Half the Time (Source: CBS News & NetAdvisor.org).
Who is Holding U.S. Debt?
We hear in some of the press that China is largest holder of U.S. debt. This was once true but not anymore. What is true is that China is the largest FOREIGN holder of U.S. debt (Source: U.S. Treasury). However China is not the largest holder of U.S. debt. In fact, China is the #3 largest holder of U.S. debt (Source: CNBC). The second largest holder of U.S. debt tends to be individuals and U.S. savings bonds – holding around $1.5 Trillion (Source: CNBC). The #1 largest holder of U.S. debt is: The Federal Reserve. In fact, according to CNBC, the FED is holding some $5.3 Trillion of U.S. debt – FIVE TIMES more debt than China.
Why is the FED the Largest Holder of U.S. Debt?
We would argue that the FED is the only entity willing (or arguably politically influenced) to print money and buy U.S. Treasury securities (U.S. debt) so the U.S. government can meet its deficit spending habit.
“The Federal Reserve likely will make life more difficult for Congress this week by affirming the June end of its controversial $900 billion bond-buying program that has financed a large part of the government’s record $1.6 trillion budget deficit this year.”
— Source: Washington Times, 04-26-2011
There is no other county or investor who has bought U.S. Treasuries like the FED has thus making the FED the largest buyer of U.S. debt, and thus the largest financier of U.S. debt.
The FED is acting as an enabler so the U.S. government can keep on deficit spending. The result of this along with government unwilling to make real deficit cuts, government unwilling to create a balanced budget, and government unwilling to make real fiscal responsibility clearly led the S&P’s down grade of U.S. credit.
Market Reaction?
It will be important to watch how financial markets react to this move. Watch Sunday, August 7th in the late eve to Japan who will be the first market to react to the news. The European markets will follow thereafter, then the U.S. markets will open Monday August 8. Our current view is that it would be a surprise if the foreign or U.S. markets have little to no reaction to the downgrade news.
The financial markets are currently in oversold territory (please see chart), but with this U.S. downgrade news, could increase a bit more volatility.
08.07.2011 Update:________________________________________________
The Israeli stock market delayed its opening by 45 minuets Sunday August 7, 2011, then plunged 7% on the back of S&P’s downgrade of the U.S. debt rating (Source: VoiceofAmerica). The big test will be to watch Japan and Europe. Japan is the 4th largest holder of U.S. debt. Their market response would likely have an influence on U.S. markets. Europe will be a bigger key to watch as many major U.S. companies trade on European stock exchanges.
Standard & Poor’s managing director John Chambers said on August 7, 2011 that there is a 1 in 3 chance of a further U.S. downgrade within the next six months to 24 months if deficit problems persist.
“…if the fiscal position of the United States deteriorates further or if the political gridlock becomes more entrenched, then that could lead to a downgrade. The outlook indicates at least a one in three chance of a downgrade over that period.”
— John Chambers, Managing Director at Standard & Poor’s (Source: Reuters)
The news of the U.S. downgrade and warning of a future downgrade at this point is likely to place a shock-wave to the U.S. financial markets. We are predicting a 457 to 687 point drop or 4 to 6% drop in the Dow on Monday 08-08-11. Since the U.S. has never had its credit downgraded, it is possible that these numbers could get worse.
The Volatility Index (the VIX) could easily skyrocket to a new 52-week high around 40 or higher. If the VIX climbs to say 43, from Friday’s 08-05-2011 close at 32, that would be a 35% jump.
The other side of the argument is that market’s recent 10% plunge could have already been factoring in a down-grade of U.S. debt. If this is the case, then the drop may not be as severe, but we still think it will have a nasty but hopefully brief shock.
The U.S. stock market based on the S&P 500 Index is technically oversold (see chart). So some technical short-term rebound in the market after a sharp fall would be in order. If the economy continues its negative trend, the market will likely follow.
The only thing that could help slow the market plunge right now is if the key leading nations attempt some maneuver to prop up the financial markets. We don’t think that global governments will be able to out-power the free market. Stay tuned.
Follow us live on Twitter Monday for real-time market commentary.
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Chart Source: Congressional Budget Office
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