As U.S. Credit Downgrade Looms, Municipalities And Pension Funds Seen To Be At Risk

NEW YORK -- For municipalities struggling to get their finances in order and for the professionals who oversee their investments, the battle being waged in Washington over the federal debt ceiling has become an urgent source of worry.

It now seems likely that a major credit rating agency will dock the sterling grade on U.S. government debt, some economists say. That prospect has sowed fear among some investment managers and the local leaders who have been working to repair municipal budgets battered from the Great Recession. A loss of the government's top rating, which Treasury debt has held for nearly a century, could raise the cost of borrowing for entities across the nation and infuse markets with a perilous shot of volatility.

"It would really start to set us back at a time when we've finally been turning the corner in a positive way," said Thomas DiNapoli, the New York state comptroller.

As New York's chief fiscal officer, DiNapoli oversees the state's roughly $134 billion pension fund, which is heavily invested in equities. With just days remaining before the U.S. Treasury has said it will exhaust its borrowing authority, stocks have lurched downward for much of the week.

"We have enough that creates vulnerability. This added issue just creates a risk that we don't need," DiNapoli added. "It's been a strong recovery for most funds -- and certainly for ours -- but we're all very aware that it's a tenuous and fragile recovery."

As DiNapoli was quick to acknowledge, nobody can say with certainty what would happen in the event of a credit downgrade. How severe the effects would be, how broadly the ripples would reach and how long the difficulty would last -- these unknowns plague the professionals whose jobs involve minimizing risk. A maddening aspect of the political stalemate, these experts say, is that federal lawmakers are treading in uncharted territory, introducing unprecedented risks into the economy.

The three major rating agencies -- Moody's Investors Service, Standard & Poor's Financial Services and Fitch Ratings -- have each warned they could cut the U.S. government's rating if Congress does not raise the debt limit soon enough to avoid default. A majority of economists in a recent Reuters poll said they expect the U.S. to suffer a downgrade from at least one of these three companies.

The consequences of a downgrade could be far-reaching. Ratings enjoy a prominent status in the global financial system and in the legal regulatory structure, despite glaring examples of their inaccuracy. Many investors have treated ratings as authoritative assessments of credit quality. Some institutional investors, such as pension funds, are required to purchase highly rated securities.

While the effects of a downgrade can't be known for sure, economists say interest rates on Treasury debt would rise, making it more expensive for the federal government to borrow money. A downgrade could increase borrowing costs for the Treasury -- and by extension, for U.S. taxpayers -- by $100 billion a year, said Terry Belton, global head of fixed income strategy at JPMorgan Chase, during a conference call this week.

A downgrade could also push up other interest rates that are tied to the Treasury rate. It could raise the cost of taking out a mortgage, a student loan, an auto loan or a credit card loan, economists say.

Even if lawmakers strike a deal to raise the $14.3 trillion debt ceiling on time, the government still might lose its top rating. Standard & Poor's has said that if the deal to increase borrowing authority does not include a "realistic and credible" plan to reduce the federal budget deficit, the company could issue a downgrade.

In a report released last week, S&P describes this scenario: the debt ceiling is raised and there's no default, but the "fiscal consolidation plan" is deemed inadequate. That would entail a downgrade to AA from AAA within three months, S&P said.

"This outcome would be very close to the status quo, mirroring times past when Congress routinely raised the debt ceiling limit without making any tough budget decisions," the report says, as it describes the potential effects of a downgrade in eerily clinical language.

It's longer-term U.S. debt that would likely suffer, experts say. Some money market funds are required to hold AAA-rated investments, and a downgrade could prompt them to sell long-term Treasury securities, said Andrew Lo, a professor of finance at the MIT Sloan School of Management. That in turn might incite a period of panic, he said.

"Any time you have any kind of coordinated divestiture, there's always the risk of a panic and a bank run," Lo said. "But instead of a run on a bank, it's going to be a run on money market funds."

But again, the outcome isn't certain. Other commentators have said that in order to induce a sell-off, the downgrade would have to be more severe than the rating agencies are threatening.

Lo is the chairman and chief investment strategist of the hedge fund AlphaSimplex, whose investments include 10-year Treasury securities. Like funds of all sorts, AlphaSimplex is preparing for the possibility of a Treasury downgrade.

"We are watching markets very carefully for these kinds of dislocations, and we are managing our risks very actively," Lo said. "We're repositioning our portfolios to both prepare for, and possibility take advantage of, these kinds of gyrations. This is really an extraordinary event that I think everybody has to be wary of."

While a downgrade could cause turmoil in financial markets, it also could deal damage elsewhere -- to the rating agencies themselves, as the logic of their rating system might fall apart. Treasury securities are a cornerstone of global financial markets, and their yield is considered the risk-free rate. A rating of AA may defy logic, said Matt Fabian, managing director of the Concord, Mass.-based strategy firm Municipal Market Advisors.

"They are reducing the utility of their own product," Fabian said. "A rating scale that shows the state of Utah, or the nation of France, as a safer credit than the U.S. government is less credible than one that doesn't do that."

"They would just be accelerating the demise of ratings," he added.

Under Standard & Poor's current ratings framework, there are 107 corporate or local government entities that bear a higher rating than the sovereign credit of the nation where they're located, according to a July report from the company. Nations with ratings in the AA range that are home to more highly rated entities include Japan, New Zealand and Spain.

S&P and Moody's have both said that they would automatically downgrade other credits if they downgraded the U.S. -- itself a prospect that has experts worried. These entities could include the mortgage giants Fannie Mae and Freddie Mac, and potentially thousands of other issuers of municipal debt. Cities and states across the nation could see their ratings docked.

"Certain debt issues are, by our criteria, directly linked to the sovereign rating and will move in lockstep with it without regard to other factors," S&P said in its report last week.

State and local governments rely on the federal government for aid, and if the government were to cut spending -- either as part of a deficit-reduction deal, or as a result of a failure to increase the debt ceiling on time -- that could wreak havoc among already-struggling municipalities.

"It would have a devastating impact, certainly on us and probably many other cities as well," Vincent Gray, the mayor of the District of Columbia, said in an interview. "Given the very fragile situation we have with joblessness -- we've still got a pretty high level of unemployment here in the city -- I think it would further exacerbate that."

Some experts said the effects of a downgrade, though potentially damaging in the short-term, would ultimately smooth out, as markets would adjust to lower-rated Treasury debt.

"After the downgrade, and after the turmoil, everything would probably go back to the way it was before," said Kevin Logan, chief U.S. economist at HSBC.

"There's no alternative" to Treasury securities, he added. "There's nothing else that can serve this purpose. There's nothing else that will fit all these requirements that they're currently being used for."

As financial professionals and elected officials keep a close eye on the debate in Washington, many expressed a feeling of frustration that a political fight might spark a real economic crisis.

"The United States is probably the only country in the history of modern financial markets that has created a situation like this by its own design," said Lo, of MIT. "We have the money to pay for it -- we just don't want to, which is absolutely insane."