Why S&P Had to Downgrade the U.S.

Geithner, stock markets react with shock to downgrade that was a long time coming.

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It may be time to lay off of Standard and Poor's.

Months after first threatening to do so, Standard & Poor's on Friday night downgraded U.S. sovereign debt from AAA to AA+ status, citing both the country's growing debt and propensity for political gridlock. The agency has taken a public beating since the decision, which led to the Dow Jones Industrial Average plummeting 634 points today.

While the downgrade has caused widespread anger and market shock, it was nevertheless a long time in coming. In April, S&P shifted the U.S. credit outlook to "negative." Then in July, the agency indicated that deficit reduction of less than $4 trillion over the next 10 to 12 years would cause the agency to consider downgrading the nation's credit.

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In issuing this concrete warning, says economist Conrad DeQuadros of economic consulting firm RDQ Economics, the agency "put itself in a difficult position." He continues, "If they had said they required $4 trillion to retain a triple-A rating and didn't get spending cuts, didn't downgrade, there would be a credibility issue there for S&P. They sort of had to downgrade the U.S."

DeQuadros is quick to add, however, that the downgrade was still justified. "I think they've made a strong case and the administration is being a big petulant with this."

The Treasury Department responded to Friday's announcement by blasting the agency. "I think S&P has shown really terrible judgment and they've handled themselves very poorly, and they've shown a stunning lack of knowledge about basic U.S. fiscal math," Sec. Timothy Geithner told NBC on Sunday. "I think they drew exactly the wrong conclusion."

The Treasury gained further ammunition when it found a $2-trillion error in S&P's initial calculations justifying the downgrade. "After Treasury pointed out this error—a basic math error of significant consequence—S&P still chose to proceed with their flawed judgment by simply changing their principal rationale for their credit rating decision from an economic one to a political one," Acting Assistant Secretary for Economic Policy John Bellows wrote on the Treasury website on Saturday.

[Read why the S&P downgrade is not likely to end partisan gridlock.]

By Monday, the administration had tempered its response. At a White House press conference, the president treated the downgrade as unfortunate but downplayed its political import. "We didn't need a ratings agency to tell us that we need a balanced, long-term approach to deficit reduction," said Obama.

A public flogging is nothing new to the nation's largest ratings agencies, whose mistaken assessments of the risks of instruments like residential mortgage-backed securities and collateralized debt obligations were among the key catalysts of the financial crisis that kicked off the Great Recession.

However, says DeQuadros, sovereign debt and mortgage-backed securities are two very different beasts. "I think there are things [the ratings agencies] are generally thought to do well. And ratings of sovereigns, ratings of municipal securities, those are security classes that agencies have been dealing with for a long time."

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Ironically, the only entity that has not responded with consternation is the bond market. The AA+ rating has yet to shake the widespread belief that U.S. treasuries are a secure investment. Yields on U.S. 10-year treasuries have actually dropped since Friday's announcement, as investors rushed into Treasuries in a flight to safety from riskier assets such as stocks.

"I don't think [the bond market is] ignoring the downgrade, but not really making it a huge weighting in their overall assessment of the value of U.S. treasuries," said Erik Ristuben, Chief Investment officer of Client Investment Strategies at Russell Investments, a Seattle-based financial services firm.

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