A U.S. Downgrade, the Worst Case Scenario

With only a handful of days left until the August 2^nd deadline, investors are appropriately worried about two things: the debt ceiling debacle and the threat of a ratings downgrade. Most analysts don’t believe that American politicians will (grand) stand in the way of doing the right thing in the short term, i.e. getting the debt ceiling raised, thus avoiding a debt default. Some bookmakers believe that there’s a near zero chance that a default is imminent, but even if it occurs, most analysts agree that at worst it will last for a day or so.

On the other hand, it’s about even money for a ratings downgrade, and the repercussions of that will be much longer lasting. Certainly, analysts are exceedingly concerned that U.S. lawmakers won’t act appropriately in the medium to long term and take a serious whack at fiscal reform. According to Michael McKenzie, the Financial Times’ U.S. market correspondent, U.S. politicians will probably use slight of hand to get a deal cut to raise the debt ceiling, but if it isn’t accompanied by fundamental reform, a downgrade is likely.

Most analysts agree that if Moody’s, S&P or Fitch ratings downgrade is forthcoming it will be that – the absence of fundamental fiscal reform – which will be the reason for it, not the missing of the debt deadline, as irresponsible as that would be.

And a ratings downgrade would have immediate and immeasurable effects. Basically, if the U.S.’s rating is notched down to AA, then everything below that rating also gets notched down. And anything backed by U.S. Treasuries – like the FDIC, Fannie Mae, Freddie Mac, etc., all of those get downgraded, too.

But it’s not just government-sponsored entities, it’s also global governments, central banks, domestic banks, insurance companies, pension funds, mutual funds, individual investors – it’s any entity that holds U.S. assets which will suffer from the downgrade.  The dominoes would begin to topple, one by one, as all of those entities scramble to shore up their now diminished holdings.  Michael McKenzie likens it to the financial crisis of 2008; as he puts it, “the deleveraging event would ripple out across the financial markets.”

A debt default would be embarrassingly painful, but the pain would be short-lived. The aftermath of a ratings downgrade, however, would be even more painful, more wide-spread, and much more enduring.