Commentary Magazine


Topic: Fitch

Credit Ratings and the Debt

Fitch, one of the three credit rating agencies (the other two are Standard and Poor’s and Moody’s), warned yesterday that it has put the federal government on “negative watch” with regard to its credit rating, which Fitch has now at its highest, AAA. Standard and Poor’s lowered the country’s credit rating two years ago, during the last debt ceiling crisis, to AA. Moody’s has not indicated any change in its rating is pending.

It is the job of credit rating agencies to assess the risk in any security, whether governmental or corporate, and reflect that risk in its rating. AAA means that there is virtually no risk of a failure to pay principal or interest. In Fitch’s rating system, the bottom is D, which means that the security is already in default and unlikely to have any worth in the future. Illinois, which has horrendous pension liabilities and a political deadlock on dealing with them, has the lowest rating of any state (A-, with a negative outlook, on Fitch). That’s still investment grade, but a full six notches below the top rating.

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Fitch, one of the three credit rating agencies (the other two are Standard and Poor’s and Moody’s), warned yesterday that it has put the federal government on “negative watch” with regard to its credit rating, which Fitch has now at its highest, AAA. Standard and Poor’s lowered the country’s credit rating two years ago, during the last debt ceiling crisis, to AA. Moody’s has not indicated any change in its rating is pending.

It is the job of credit rating agencies to assess the risk in any security, whether governmental or corporate, and reflect that risk in its rating. AAA means that there is virtually no risk of a failure to pay principal or interest. In Fitch’s rating system, the bottom is D, which means that the security is already in default and unlikely to have any worth in the future. Illinois, which has horrendous pension liabilities and a political deadlock on dealing with them, has the lowest rating of any state (A-, with a negative outlook, on Fitch). That’s still investment grade, but a full six notches below the top rating.

The agencies don’t always get it right, of course. They all completely failed to see the risk in mortgage-backed securities and rated them AAA. When the housing bubble collapsed, many of the subprime mortgages lurched into foreclosure. That made the bonds they (along with non-subprime mortgages) collateralized unsellable because no one knew the value of the underlying assets. Unsellable securities are, by economic definition, worthless. Unfortunately, many of the too-big-to-fail banks had loaded up on these mortgage-backed securities because of their AAA ratings and relatively good yields. When the market in those bonds cratered during the crisis, some of those banks became technically insolvent. The Treasury had to ride to the rescue with TARP money lest the entire United States banking system collapse. (Once the dust settled, and the market for mortgage-backed securities came back to life, the banks were able to pay back the TARP money.)

What would a cut in the government’s credit rating mean? Principally, it would be a huge political embarrassment. The United States is, by far, the richest country the world has ever known. The federal government’s annual income from taxes and fees ($2.7 trillion in 2013) exceeds the total GDP of all but five countries. So to have its credit rating knocked down would be an embarrassment perhaps on a par with Warren Buffett having his American Express card declined at a restaurant.

More significant, credit ratings determine relative interest rates. One of the iron laws of economics is that risk and reward must balance (at least in the long term). The greater the risk, the greater the reward, in terms of interest income, must be to get buyers to hold your paper. Since the United States owes $17 trillion, a mere one-percentage point increase in interest costs would add $170 billion to the cost of servicing the debt. (About one-third of the debt turns over every year.) With interest rates likely to begin to creep up as the Fed slowly cuts back on its stimulus, the percentage of federal revenues that have to be used for debt service will rise anyway. Any significant addition to that burden would seriously impact federal spending in other areas.

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