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Gauging Uncle Sam's credit risk

February 07, 2009|TOM PETRUNO

Just how creditworthy is the United States of America?

Right now, in the eyes of the official arbiters of credit grades -- Standard & Poor's and Moody's Investors Service -- Uncle Sam still deserves the highest rating of AAA.

But as the government's costs to bail out the economy and the financial system mount, S&P and Moody's in the last month have had to address the unthinkable: whether America might warrant a debt downgrade.

If the U.S. were to fall to, say, AA-plus on S&P's scale, we'd be rated the same as Belgium. At A-plus, we'd be in the ranks with Italy.

And at just plain A, the U.S. would be on the same level as its largest state, California -- whose debt rating S&P cut this week to the lowest of any state because of the continuing budget impasse.

So far, the raters don't see a U.S. downgrade as imminent. But they're raising the same questions that are on the minds of millions of Americans: Can we afford these bailouts? Are we choosing short-term fixes that will hurt us in the long run?

In a report this week, Moody's said its AAA rating on U.S. Treasury debt was based on the "very high degree of economic and institutional strength" the U.S. has enjoyed historically.

Still, the firm noted that federal finances "have been substantially worsened by the credit crisis, recession and government spending to address these shocks."

S&P, which affirmed its AAA rating on U.S. bonds last month, conceded that the risk to the nation's fiscal health had "noticeably increased" but said America retained its core appeal as a "high income, highly diversified, exceptionally flexible economy."

Of course, S&P and Moody's are the same folks who failed to see the housing bust coming and affixed top-scale credit grades to mortgage securities that now trade for pennies on the dollar.

The derisive view of the debt raters is that they may be the last to know if America no longer is truly a AAA borrower.

Chances are, the marketplace would make that judgment before S&P and Moody's would. It would be evident in surging interest rates on Treasury bonds, if investors judged that they should be paid significantly more to compensate for greater risks entailed in lending to the U.S.

At the end of last year, no one cared to question America's AAA rating. Yields on Treasury securities were at generational or all-time lows -- a function of the extraordinary level of fear in financial markets amid the global credit meltdown.

Many investors didn't care what government bonds paid; they just wanted absolute safety of principal, and that's what Treasury issues offered. So money poured in.

This year, the market's mind-set has shifted notably. Yields on longer-term Treasury bonds have jumped. In part, that suggests a lessening of fear, which is good news. But it also reflects investors' growing concern about the Treasury's need to borrow as much as $2 trillion this year to finance the rescue of the economy and financial system.

The yield on the 10-year Treasury note, a benchmark for mortgages and other interest rates, reached 2.98% on Friday, up from a recent low of 2.06% on Dec. 30.

A 2.98% yield on a 10-year note still is a very low rate, historically. Even so, the simple message from investors to the Treasury has been, "If you want our money, you'll have to pay more for it."

But is that because the U.S. is perceived to be a riskier borrower -- something less than AAA?

The risks involved in lending to a country are different from those in lending to businesses. A company can run out of money to pay creditors. Sovereign nations, on the other hand, always can print cash to cover debts.

The latter option, however, creates another risk: By borrowing excessively, then running the presses to pay those debts, a nation can fuel an inflationary spiral -- the classic case of "too many dollars chasing too few goods and services."

Inflation is the scourge of investors who own fixed-rate bonds because it devalues those securities, particularly if the bonds' fixed yields are low to begin with, as Treasury yields are today.

That's the risk signaled by the snap-back in government bond yields this year, said Paul Kasriel, chief economist at Northern Trust in Chicago. "The real question is how much of [bond] investors' purchasing power will be lost" if inflation rises down the road, he said.

For the moment, the Obama administration and Congress -- and many Americans -- believe there's no alternative but to borrow heavily and spend on the bailouts. If the fixes work, and the economy recovers, inflation is likely to be the government's next battle.

But for bond investors, that risk has to be factored into the fixed yields they're willing to accept today.

From the rating companies' viewpoint, whether the U.S. can hold on to its AAA credit grade in the next few years may come down to some standard measures of sovereign debtor risk -- for example, total government debt held by investors compared with the size of the economy.

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