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S&P Downgrade: 8 Reasons Why the Panic Is Misplaced

This post was updated on August 17, 2011.
The overwrought reaction to Standard & Poor's downgrade of Treasury debt says less about the state of America's public finances than the state of mind of the American public. After a dreadful week in the financial markets, some commentators responded to the S&P downgrade by predicting an acceleration of the decline in stocks and a run on the dollar and Treasury bonds. But while stocks did sell off that Monday morning after the downgrade, there are good reasons to expect stability to be restored across the markets soon. Here's why:

S&P had assigned Treasury debt a negative outlook already, meaning that a 50-50 shot of a downgrade in a matter of months existed. Being shocked by the downgrade is like being shocked that a coin flip came up tails. Being shocked by the downgrade after the unwholesome debt ceiling negotiations and the meager spending cuts that came out of them (posts on the debt ceiling are here and here) is like being shocked that the flip of a coin with tails on both sides came up tails.

Much concern centers on the prospect of a domino effect as downgrades spread to insurance companies, municipalities and others whose own debt is backed by Treasuries, or else on the possibility of forced selling by investment funds that have to hold AAA paper. But the two other principal credit agencies, Moody's Investors Service and Fitch Ratings, reaffirmed the Treasury's AAA rating, so why would Treasury debt no longer broadly be considered AAA? Why is it that only S&P's rating matters?

An entry in a Wall Street Journal blog on the reaction to the downgrade points out that S&P assigned AAA ratings to mortgage securities that blew up in 2008, leading to the financial crisis that led to the recession that led to the high fiscal deficits that led to the S&P Treasury downgrade. A piece on Fortune's website notes that rating agencies generally have a poor record of identifying companies - Bear Stearns, WorldCom, Enron - that are about to default, so why take this move so seriously?

Click to the next page for more reasons that the downgrade matters less than many seem to think.

Professional investors rely on rating agencies to evaluate obscure debt issues that investors don't have the time or resources to assess for themselves, even if the raters don't always do a fabulous job of it. The huge, liquid, transparent Treasury market is a different story. Portfolio managers and Wall Street traders probably can evaluate the creditworthiness of Treasury debt all on their own.

An AAA rating is better than the AA+ rating that S&P has just conferred on the Treasury -- there's one more A so it has to be, right? -- and there is bound to be a loss of prestige for the Untied States and some political fallout. But AA+ countries default about as often as AAA countries -- never -- and so the downgrade should have little practical effect once the initial turbulence subsides and the pros resume control of Treasury market trading. Another entry in the Journal blog puts it like this: "The likelihood of getting paid back by a AA+ credit is considered 'very strong,' while a AAA credit's likelihood of paying you back is 'extremely strong.' See the difference? Me neither."
If investors bailed out of Treasury bonds, what would they bail into? The next largest debt markets are Japan and Italy. Both have lower ratings than the United States, Japanese interest rates are lower, and the Italian economy is more mismanaged than the American economy by a wide margin. A dozen or so other nations have an AAA rating, but their bond markets are smaller, and many of them have a higher risk of default factored into their prices, despite what S&P thinks.

The downgrade is likely to concentrate minds in Washington. Look for the Federal Reserve to drop hints this week of a QE3. The prevailing assumption on Wall Street seems to be that the Fed has less ammunition at its disposal than before the first two rounds of quantitative easing, but with expectations so low, an allusion to QE3 could still help markets stabilize or even improve.

Speaking of low expectations, our political leaders did not exactly acquit themselves admirably during the debt ceiling debate, but the panic that the S&P move is inspiring could be a catalyst for real change in the way the federal government handles our finances. It could make the political cost of not dealing with the deficit higher than the cost of dealing with it. It's probably a long shot, but if it happens, it's likely to raise stock prices and lower interest rates.

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