–Retransmitting Updated Story Headlined 20:14 ET Fri;S&P Response
–Downgrades US Sovereign Rating a Notch to AA+, Outlook Negative
–Administration Says S&P Had $2 Trillion Flaw; Ignored Progress

By Denny Gulino, Brai Odion-Esene and Alyce Andres-Frantz

WASHINGTON (MNI) – Standard and Poor’s late Friday downgraded the
70-year-old credit rating of Treasury securities one notch and
threatened to do it again if there is insufficient progress in curbing
the nation’s debt load.

The gold-plated AAA rating went to AA+ and the outlook was deemed
negative by S&P, the most followed of the international ratings
agencies.

The Treasury Department immediately reacted, saying, “A judgment
flawed by a $2 trillion error speaks for itself.”

Administration sources went further late Friday, saying the stance
of U.S. Treasuries in the market should not be changed, at least as long
as Moody’s and Fitch retain their top U.S. rating. The downgrade, they
said, has no economic justification.

S&P also aimed identical downgrades at the Federal Reserve and the
New York Fed and will follow Monday to apply it to all government-linked
entities, including Fannie Mae and Freddie Mac.

The Fed and other U.S. banking regulators quickly advised financial
institutions that the U.S. downgrade will have no effect on the risk
weighting of Treasuries or any other government-linked securities,
such as agencies.

The error the Treasury Department spokesman alleged was in a
miscalculation of future discretionary spending that S&P acknowledged
and revised.

S&P issued a separate response to Treasury’s criticism of its
admitted $2 trillion miscalculation, revised out of its final downgrade
report.

The ratings agency responded that “the ratings decision to lower
the long-term rating to AA+ from AAA was not affected by the change of
assumptions regarding the pace of discretionary spending growth.”

The change means only a $345 billion difference in the near term
horizon S&P used for its downgrade decision and the $2 trillion
difference in baseline assumptions would apply only in a 10-year
horizon, the agency said.

None of the key factors in the decision “was meaningfully affected
by the assumption revisions to the assumed growth of discretionary
outlays and thus had no impact on the rating decision,” S&P said.

In the original announcement, S&P said it does believe the new
Budget Control Act Amendment “has removed any perceived immediate threat
of payment default” but nevertheless went on to say, “The political
brinksmanship of recent months highlights what we see as America’s
governance and policymaking becoming less stable, less effective and
less predictable.”

Republicans and Democrats, S&P said, “have only been able to agree
to relatively modest savings on discretionary spending while delegating
to the Select Committee decision on more comprehensive measures.”

Tax hikes and other new revenues “have dropped down on the menu of
policy options,” the statement continued, and elected officials “remain
wary of tackling the structural issues.”

The difficulty in the U.S. of “framing a consensus on fiscal policy
weakens the government’s ability to manage public finances,” S&P said.

S&P said that if the second-step deficit reduction of $1.2 billion
does not occur there could be “a possible further downgrade to AA.”

The ratings agency said the U.S. debt trajectory is “diverging”
from that of its peers, Canada, France, Germany and the UK. They will
have debt-to-GDP ratios this year ranging from Canada’s 34% to the UK’s
80% while the U.S.’s ratio will be 74%. However by 2015, S&P said, their
net public debt burdens will begin to decline “in contrast with the
U.S.”

Administration sources said S&P had been threatening the downgrade
all week and Friday afternoon had let the Treasury Department see its
documents. After a couple of hours of analysis Treasury rejected the
rationale, saying it was based on a $2 trillion mathematical
miscalculation. S&P agreed, modified its documents, then issued the
downgrade anyway shortly after 8 p.m.

Administration sources reacted angrily, accusing S&P of paying more
attention to the messy process of raising the debt ceiling than on the
outcome, which they said is a credible path toward a meaningful
reduction in the growth of U.S. debt.

They also said S&P’s revised rationale was grounded in political
analysis and had no economic justification once the $2 trillion error in
discretionary spending estimates based on the Congressional Budget
Office was corrected.

The deficit cuts to come, the administration sources said, will
relatively stabilize the U.S. debt-to-GDP ratio within the 10-year
window, not see it continuing to worsen as S&P described.

When asked what the market effect will be of the downgrade, the
administration sources said that it could be minimal as long as Moody’s
and Fitch maintained the U.S. AAA. Moody’s placed the U.S. on a negative
watch but this week affirmed the AAA standing.

As MNI reported at the time, on Tuesday, July 26, JP Morgan Chase’s
Terry Belton told reporters on a conference call his firm estimates a
downgrade would increase borrowing costs by as much as $100 billion a
year, adding 60 to 70 basis points to Treasuries yields.

The day before, a senior advisor at the IMF, Rodrigo Valdes, said a
downgrade could bring “a lot of uncertainty” and be “very damaging both
for the U.S. economy and the rest of the world” although no one knows
what the exact effects would be.

Now the United States is about to find out what happens, beginning
when Asian markets open Sunday night, followed by European markets, both
hard hit already in selloffs Thursday and Friday. Given that a downgrade
of U.S. securities is unprecedented, analysts had no sure basis to
predict how the markets may react.

The S&P statement made clear the impact of the bruising weeks of
partisan battling on Capitol Hill over the debt ceiling that did not
resolve itself into an agreement with the White House until Sunday. By
then the world had been treated to a spectacle of high-level Americean
governmental paralysis even in the face of a Tuesday midnight deadline.
Missing that deadline would have meant Treasury would have had to stop
paying some of its bills, if not stop servicing its debt.

The agreement turned out to be a convoluted three-step affair
beginning with a $400 billion lift to the borrowing ceiling together
with the appointment of a speical 12-member bipartisan congressional
committee to recommend $1.2 trillion in budget cuts in 50 days.

The prescribed second step cited by S&P as a possible trigger for a
second downgrade was more circuitous, opening the way to a likely
congressional joint resolution of disapproval of another increase in the
debt ceiling, then a presidential veto and an uncertain effort to
override the veto. Without that override, Treasury would be back to
“extraordinary measures” to avoid breaching the debt limit, an official
told Market News International Wednesday, as the quarterly borrowing
schedule was announced.

S&P affirmed the USA A-1+ short-term rating. The ratings agency had
originally assigned a negative outlook to the long-term rating in April
and Treasury officials had expected the next shoe to drop within 90 days
though not necessarily an action as serious as a downgrade. Since April,
the “effectiveness, stability and predictability of American
policymaking and political institutions have weakened” more than
expected.

The six Republican and six Democratic members of the new Select
Committee on budget control must be chosen by congressional leaders in
the next few days. Those members are expected to be chosen chiefly for
their loyalty to their party’s leadership in Congress, excluding the
more extreme elements who could follow their own agendas.

But the uncertainty of the process weighed on S&P’s analysts who
would rather have seen the “grand bargain” option resulting in immediate
deficit reduction of around $4 trillion. Instead the “grand bargain”
escaped the negotiators from Capitol Hill and the White House making the
much less ambitious — some critics have said toothless — compromise
passed by the two chambers Sunday and Monday.

S&P called the compromise arrangement a “legislative mechanism that
leaves open the details of what is finally agreed to until the end of
2011, and Congress and the Administration could modify any agreement in
the future.”

Since Republicans are opposed to “any measure that would raise
revenues” S&P said it has changed its assumption that the 2001 and 2003
tax cuts due to expire by the end of 2012 actually will expire.

S&P also cited the large revision to first-quarter GDP on July 29,
in which the growth rate was pegged at only 0.4% followed by an anemic
second quarter. “The revisions show that the recent recession was deeper
than previously assumed,” S&P said. That makes the debt burden “slightly
higher.” So S&P’s “downside case scenario” assumed GDP grows just 2.5%
annually going forward.

S&P concluded that “the outlook on the long-term rating is
negative” and a higher public debt trajectory “could lead us to lower
the long-term rating again.”

** Market News International Washington Bureau: 202-371-2121 **

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