Mounting U.S. Debt Raising Concerns

Rating agencies say a downgrade from the top rating is unlikely but is no longer out of the question.

By Jerome Idaszak, Associate Editor, The Kiplinger Letter

August 27, 2008

The idea of the U.S. losing its AAA debt rating isn’t far-fetched anymore. Standard & Poor's credit rating agency says the U.S. is taking on a huge risk in its commitment to back up troubled mortgage giants Fannie Mae and Freddie Mac. The duo hold, or guarantee, mortgages worth about $5 trillion, or about half of all outstanding U.S. mortgages. The figure also is almost half of the current total U.S. debt, now at $9.5 trillion.

Most analysts are not predicting a worst-case scenario in which the economy goes into a 1930s-like brutal and prolonged decline. But if it happened, most of Fannie and Freddie’s obligations would be taken over by the Treasury. John Chambers, chairman of S&P's sovereign rating committee, says his firm doesn’t expect a steep recession. But he is quick to add that "a severe stress scenario" poses a threat to the top-of-the-heap rating U.S. debt now enjoys.

Downgrades result in having to offer higher interest rates on new bonds sold to the public. And the value of outstanding bonds declines, hurting investors and the issuer, which in this case is the United States. Companies and countries suffer the same fate when their credit ratings are taken down a notch. A lower rating makes borrowing more expensive as investors, including mutual funds, pension funds, banks, and state, local and foreign governments, insist on higher yields in return for taking on a higher level of risk.

Downgrades to large and industrialized nations do happen. Earlier in August, S&P took Argentina down a notch. And during 2001, when Japan’s economy was reeling and its banks were wobbly, that nation lost its AAA rating.

Counting current and future obligations, the U.S. is $50 trillion in the hole, according to David Walker, former comptroller general of the U.S. He cites current debt held by the public plus about $7 trillion in Social Security IOUs and $34 trillion worth of obligations for Medicare benefits under current law.

The U.S. has held a AAA rating since the 1920s, but the fallout from the housing crisis has S&P, among others, expressing concern. And it’s not just the woes of Fannie and Freddie that are worrisome. Moody's has warned the U.S. about its looming future obligations to Social Security and Medicare recipients. And the federal budget deficit is rising, worsened by the cost of another year of war in Iraq. In the fiscal year starting Oct. 1, the budget deficit likely will top $500 billion.

There could be a silver lining to all the chatter about U.S. debt quality. The more rating agencies, regulators and investors talk about a debt downgrade, the more pressure it puts on Congress to slim down the annual budget deficit and to tackle long overdue changes in Medicare, where costs have doubled over the past decade to $391 billion a year.

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