Why a U.S. Credit Rating Downgrade is On the Way

It's been 18 months since Standard & Poor's lowered the U.S. credit rating, and now Moody's Corp. (NYSE: MCO) and Fitch Ratings look ready to do the same.

That's because even after the fiscal cliff deal, the country's biggest financial problems still remain: the debt ceiling debate, the uncertainty over the delayed sequester cuts and the failure to address the escalating long-term national debt.

And there's little confidence in Congress to reach an effective long-term deficit-reduction agreement by the February deadline.

"It's a fait accompli, actually," Money Morning Chief Investment Strategist Keith Fitz-Gerald said of a credit rating downgrade. "We are the most indebted nation on the face of the planet, spending has ground to a halt, lending is not happening."

Signs a U.S. Credit Rating Downgrade is Near

Standard & Poor's became the first of the "Big Three" ratings agencies to downgrade the U.S. credit rating when it did so on Aug. 5, 2011. Now Moody's and Fitch could downgrade the ratings one notch from AAA to Aa1 and AA, respectively.

One of the biggest reasons to expect a downgrade is that the government has continuously failed to cut money from the bloated budget. The fiscal cliff deal did nothing to resolve our spending problem.

"The recent package mitigates part of the fiscal drag on the economy associated with the fiscal cliff but does not eliminate it," Moody's said. "It does not ... provide a basis for meaningful improvement in the government's debt ratios over the medium term. The debt trajectory resulting from this [ongoing] process is likely to determine whether the AAA rating is returned to a stable outlook or downgraded."

And Fitch said in a report last month, "If the negotiations on the fiscal cliff and raising the debt ceiling extend into 2013 and appear likely to be prolonged with adverse implications for the economy and financial stability, the U.S. sovereign rating could be subject to review, potentially leading to a negative rating action."

This fiasco is exactly what S&P predicted when it downgraded the U.S. credit rating.

In 2011, Congress bickered and squabbled over raising the debt ceiling until the last minute, almost forcing the U.S. to default on its debt.

S&P said at the time "political brinksmanship" in the debt ceiling debate had made the U.S. government's ability to manage its finances "less stable, less effective and less predictable."

When the ceiling was ultimately raised and a deficit-reduction plan was passed, S&P said the bipartisan deal that was reached fell short of what was necessary to tame the nation's debt over time, and presciently stated that leaders would not be likely to achieve more savings in the future.

Dangers of a U.S. Credit Rating Downgrade

A U.S. credit rating downgrade would likely lead to an increase in all interest rates, raising the cost of borrowing for the government and everyone else.

That, in turn, would make it more difficult and expensive for consumers to acquire mortgages and credit cards and for companies to acquire business loans.

Higher interest rates could also cause homeowners to default on mortgage payments, weakening the housing recovery just as the industry is showing signs of a rebound.

States and municipalities that have their economies tied to the federal government and could also see their credit ratings in jeopardy, as well as could face higher borrowing costs for schools, roads, hospitals and other projects.

Markets will likely tumble after a downgrade. In 2011, from Aug. 5 to Aug. 19, the S&P 500 fell about 6.3% and the Dow Jones Industrial Average slipped 5.5%.

Even speculation of a ratings change could cause a sharp sell-off in equities. The S&P 500 fell 10.8% in the two weeks prior to Standard & Poor's announcing its change to the U.S. credit rating. The Dow fell 9.7% in the same period.

And the market hit could be more severe this time if not just one but two or all three of the big ratings agencies deliver a downgrade.

"In the absence of a grand bargain in the next two months, it is likely that the U.S. is downgraded," analysts led by Tom Porcelli, RBC's chief U.S. economist, wrote in a note Jan. 3.

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