Financial markets were jolted briefly today when Moody’s Investors Service announced that it was putting the Aaa credit rating of five states on review. Though some market participants were taken off guard, Moody’s had already issued a comment back in June warning that any change to the US sovereign rating would necessarily have negative implications for Aaa issuers that were linked in some way to the US government’s rating. The key for the rating agencies is a medium-term deficit reduction plan. Without one, the US sovereign credit rating could fall, followed by a cascade of other rating changes.
Obviously, ratings that are directly linked to the US government would move in lock step with the US rating. These would include Aaa issuers such as Fannie Mae and Freddie Mac. It would also include pre-refunded municipal bonds and structured securities that are collateralized with US government debt.
In addition, entities whose financial condition depends to some extent on their relationship with the federal government could also be affected. This includes states whose economies are heavily reliant on federal expenditures or whose labor forces are heavily weighted with federal employees. Of the affected states in today’s announcement, both Maryland and Virginia are close to Washington. Many federal employees and contractors live in those states. South Carolina and New Mexico have large military bases. Federal employment and procurement are high in those states. The same is true for Tennessee. For Moody’s this means that the credit standing of these states may rise and fall with the credit rating of the US government.
Financial markets should be prepared for more announcements of this sort. Both Moody’s and S&P have indicated that a wide range of issuers will be affected if the credit rating for the US is downgraded. That should be obvious for entities that are directly liked in some way to the federal government, but a ratings change may also affect other entities such as banks and insurance companies that hold large amounts of federal debt. A variety of public finance credits could be affected, especially those whose bonds are linked in some way to government guarantee programs. Ratings for structured finance transactions could also be affected, particularly for structured deals that use Treasury obligations as some form of collateral.
An increase in the federal debt limit does not mean the rating agencies will hold the line on the US triple-A rating. Unless a credible medium-term deficit reduction plan is adopted soon, the US sovereign rating could be lowered to the double-A category before the end of this year. If that happens, a cascade of other rating changes may follow.
HSBC Global Research