The U.S. default risk may be passing, but a downgrade could still lie ahead


The offices of Fitch Ratings in New York. (Justin Lane/EPA)

If the U.S. government’s credit rating is the backbone of the public financial system, then the negative credit watch issued by Fitch Ratings on Tuesday is akin to a bulging disc.

It may never cause a problem. But if it ruptures, the results could be painful. For the next few months, as the government approaches another debt limit and Fitch evaluates how the political system responds, the threat of a downgrade remains — and with it the risk of a broad rise in borrowing costs, not just for the federal government but also for countless state, city and local agencies whose credit ratings could be at risk as well.

The Fitch action highlights the central — and controversial — role played by the three large credit ratings agencies in the U.S. and global financial systems. The grades that Fitch, Moody’s and Standard & Poor’s use to rate the creditworthiness of institutions, governments and financial securities partly determine how much nations pay to raise money, how much a local sewer authority must charge its customers for debt service and whether a company can get the money it needs to build a factory.

The process is complex — combining hard data analysis, dense statistics and assessments of national politics and governance — and it sometimes has blunt results. The differences among the top ratings are not great, but a downgrade that pushes a country or company across the line from “investment grade” to “speculative” — a junk bond — can be catastrophic.

The ratings companies were criticized for the high grades given to the complex securities that helped spark the U.S. financial crisis. They were slammed in Europe as being too slow to downgrade Greece — the country kept investment-grade status through years of financial shenanigans — and too quick and vicious once they decided officials in Athens had lost credibility.

They have been studied extensively, and it remains unclear the degree to which they provide important, original information that shapes markets or lag and respond to what investors are already doing in ways that make any problems worse.

But give them this — they are generally accurate. A recent International Monetary Fund study found that the governments that have defaulted on bonds have been the ones with the lowest credit ratings. And for all the criticism, there has been no good substitute for evaluating the thousands of debt securities issued around the world each year. Europe contemplated setting up a government-run system to break away from the U.S.-based triumvirate but found it too expensive and difficult to duplicate what the companies do.

“The reliance on credit rating agencies is imperfect and easy to criticize,” said Nicolas Véron, a fellow at the Peterson Institute for International Economics who studies the European financial system. “It’s less easy to find an alternative.”

The United States and Europe have tightened the role that ratings agencies play, but their influence remains pervasive, as Maryland officials can testify.

When Moody’s placed the United States on a negative outlook for a possible downgrade in 2011, it did the same to Maryland, endangering the state’s own AAA bond rating. The U.S. outlook was returned to “stable” over the summer — and so was Maryland’s.

Fitch’s upcoming decision could be more portentous. If Fitch becomes the second of the big three to knock the United States from its AAA perch, it may result in lower ratings at the state and local level.

It would probably be only a slight nick; it is a long drop from the top ratings category that the United States shares with nations such as Germany and Canada to the junk ratings being applied to nations such as Greece.

But it’s still a move in the wrong direction that could mean local governments have to pay more to raise money to build roads, schools and hospitals.

When it issued the negative credit watch Tuesday, Fitch said it “expects to resolve” the issue by the end of March — time enough for another debt-ceiling deadline to come and go.

In recent notes, all three agencies have emphasized that the United States remains a safe bet. Even as the debt limit approached, they said the risk of a default was low. But Fitch noted that the political dysfunction could do some subtle, long-term damage.

“The prolonged negotiations over raising the debt ceiling . . . risks undermining confidence in the role of the U.S. dollar as the preeminent global reserve currency, by casting doubt over the full faith and credit of the U.S.,” the agency wrote.

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