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Political rift was tipping point in S&P warning

By Reuters
Thursday, April 21, 2011 9:04 EDT
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NEW YORK (Reuters) – For the past 928 days, Standard & Poor’s has tracked the relentless deterioration of government finances. On Monday, it made a move that could turn out to be one of its boldest calls yet.

That’s when S&P announced that it was revising the credit outlook for the United States to “negative.” Its message was simple: the country could lose its gold-plated AAA credit rating if Washington could not agree on a plan to slash the budget deficit within the next couple of years.

History does not favor the United States keeping its prized rating.

Of the four AAA-rated countries that S&P has placed on negative outlook between 1989 and this March, three were downgraded within 15 months on average. That would put July 26, 2012, as the date to watch for whether the United States loses the star credit status it has held since 1941. Such a move would likely make it much more expensive for the country to service its massive debt burden.

The decision to revise the U.S. credit outlook came during a conference call among seven S&P sovereign-debt analysts, who approved it in a simple majority vote.

S&P informed the Obama administration of its plans on the previous Friday, a White House spokesman said, though the exact timing remains murky.

What pushed the ratings committee off the fence wasn’t raw numbers. No one disputes the U.S. debt levels are too high. Both the Democratic White House and the Republican-led U.S. House agree on the need to slice about $4 trillion from the U.S. deficit over roughly a decade.

It was the poisonous politics in Washington that caused S&P to raise the red flag, interviews with S&P analysts over the past few days and its statement show. S&P since the late 1990s has added political risk to its evaluation of a country’s credit.

President Barack Obama last Wednesday offered a starkly different plan from Republican House Budget Chairman Paul Ryan on how to reduce the gigantic $14.3 trillion debt load, one that has grown by about 60 percent in less than three years. There is little hard evidence the two sides are ready to reach agreement before the 2012 election.

“The gulf has never been wider,” David Beers, the global head of Standard & Poor’s sovereign ratings team, told Reuters Insider on Monday.

“Even the president, in his speech last week highlighted that these are very big political differences. And we think it’s going to take a lot of effort and a lot of political will across the parties to bridge that gulf and do it in a way that is credible,” he added.

ABC News reported on Wednesday that the Obama administration asked S&P to hold off on issuing its report until after the president and Congress completed discussions on the 2011 budget and Obama made his deficit reduction speech on April 13.

The U.S. Treasury said it had no comment on the report. S&P spokesman David Wargin said the agency has a constant dialogue and discussions with administration officials but would not discuss timing.

“As a matter of policy we don’t comment on conversations with governments we rate.”

POLITICAL DIVIDE

The budget wrangling over the past six months had not inspired confidence at S&P, the credit ratings agency that is a division of McGraw-Hill. Ratings from S&P and Moody’s are used by investors as a guide to the riskiness of holding an issuer’s debt. Many insurance firms and pension and mutual funds rely on ratings to decide where to invest.

Since the November elections, debate in Washington has grown deeply polarized. Republicans gained control of the U.S. House with support from Tea Party activists who are determined to deliver on a platform of small government, low taxes and wiping out the federal debt.

The Republican budget, pushed by Ryan and passed by the U.S. House, would shrink role of the federal government, primarily by getting out of the business of overseeing healthcare for the poor and elderly. These programs would be turned over to states and private insurers, who would receive federal grants. It also would cut the top personal and corporate tax rate to 25 percent from 35 percent.

Obama in contrast laid out a plan last Wednesday that aims to control the costs of the Medicaid and Medicare healthcare programs, and put them onto a sound financial footing through a mixture of cost savings and streamlining. He would raise taxes on the wealthy and cut defense spending.

For S&P analysts, the key concern wasn’t the numbers. It was that neither side showed sufficient willingness to take tough political decisions so they can strike a medium-term deficit reduction plan before the 2012 presidential election. Instead they risk kicking the can down the road — and let the deficit get worse.

The past five months illustrate just how hard compromise can be. Democrats even when they controlled Congress could not agree on a fiscal 2011 budget. They left it until after the November elections. Talks went to the brink seven times, forcing Congress to pass seven temporary funding measures before they struck a budget deal for fiscal 2011 on April 8 worth $38 billion in cuts. That deal almost fell apart at the last minute when some anti-abortionist Republicans tried to tack on removing some funding for Planned Parenthood – a sign of the ideological issues caught up in the debate.

TRIGGERS

Nikola Swann is the lead analyst evaluating the U.S. rating for S&P. Based in Toronto, Canada’s financial center, he comes with strong credentials. He holds a Masters in Economics from the London School of Economics and has experience at the International Bank for Reconstruction and Development; the International Finance Corp., which is the World Bank’s money arm; and at Canada’s Finance Ministry and its central bank. He has worked at S&P since 2002.

He has authored the key reports issued by the credit agency that dissect the fiscal health of the United States and evaluate critical risks, and he prepared the recommendation to the credit committee on whether to change the U.S. rating or its outlook from stable to negative.

“The committee discussion was rigorous, examining all factors we regard as relevant. We all understood the importance of making a well-informed, thoughtful decision on this credit opinion,” Swann told Reuters by email.

He said they applied their standard sovereign ratings criteria, and strove to publish research that communicates its credit opinion.

Since becoming the lead analyst for the U.S. credit rating in 2006, Swann said the firm has pointed out U.S. fiscal weaknesses. Over the last three years those weaknesses have been amplified in nearly a dozen reports.

Until this week the good always outweighed the bad, and it kept the ratings outlook stable.

It was at the height of the financial crisis in September 2008 when S&P spelled out in a Frequently Asked Questions paper exactly what factors could provoke a downgrade of the U.S. AAA rating.

Three triggers were on its watch list: a significant jump in the U.S. debt burden; a decline in the U.S. dollar as a key global currency; and significant policy mistakes such as delays in financial sector restructuring or a rise in trade protectionism.

Already there were reasons for check marks against about half of the key indicators. The debt-to-GDP ratio was rising and foreign governments slowly are shifting assets out of the U.S. dollar, weakening its global status. These trends have persisted.

Less than a year later in June 2009, S&P called it “unlikely” it would lower the U.S. rating “in the near term.” But once again it signaled concerns about the fiscal outlook, noting the cost of assisting distressed U.S. financial institutions, and it warned of the danger of high inflation.

In January of this year, it warned that the rating would come under pressure “absent a credible plan” to tighten fiscal policy that helps stabilize the U.S. debt-to-GDP ratio, which has risen to 62.1 percent at the end of 2010 from 40.3 percent at the end of 2008. Based upon Obama’s 2012 budget proposal, the non-partisan Congressional Budget Office estimates a debt-to-GDP ratio of 73.4 percent at the end of next year.

Again roughly half the criteria for a downgrade were met.

S&P’s procedure for pulling the trigger is for the lead analyst to present recommendations to a committee of fellow analysts for the G10 economies, who discuss the findings and take a vote. They review a draft press release, which is then edited and issued shortly after the decision is made.

After repeated attempts to clarify the process in the case of the United States, S&P would not confirm the timing of its final decision, when it informed the White House or the nature of the discussions, citing company policy.

“You bring a rating to committee when the facts on the ground change, so as developments change, the ratings change,” said John Chambers, the chairman of S&P’s sovereign rating committee, told Reuters. (Reporting by Daniel Bases, Albert Yoon, Edith Honan; editing by Stella Dawson, Martin Howell and Frank McGurty)

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